First off, let’s review what value investing is. Seth Klarman, CE of the Baupost Group, provides a useful description:

“Value investing, today as in the era of Graham and Dodd, is the practice of purchasing securities or assets for less than they are worth – the proverbial dollar for 50 cents. Investing in bargain-priced securities provides a “margin of safety” – room for error, imprecision, bad luck, or the vicissitudes of the economy and stock market. While some might mistakenly consider value investing a mechanical tool for identifying bargains, it is actually a comprehensive investment philosophy that emphasizes the need to perform in-depth fundamental analysis, pursue long-term investment results, limit risk, and resist crowd psychology.” ― Seth Klarman, foreword, Security Analysis, 6th Edition

Now what is back-testing?

Investopedia provides a handy explanation:

“Backtesting allows a trader to simulate a trading strategy using historical data to generate results and analyze risk and profitability before risking any actual capital.

A well-conducted backtest that yields positive results assures traders that the strategy is fundamentally sound and is likely to yield profits when implemented in reality. A well-conducted backtest that yields suboptimal results will prompt traders to alter or reject the strategy.” ― Investopedia, reviewed by James Chen

So, what is quantitative value investing?

It is the systematic analysis of market history using value-based investing principles. It helps investors build and test a long-term investment strategy before they commit any capital.

Why is that a good idea?

An investment strategy provides an investor with a rules-based investment framework. This helps to remove emotional and psychological biases investors face when they are investing in the stock market. It helps to keep your rational-self in control and provides evidence of outperformance as well as expectations of risk going forward.

Howard Marks of Oak Tree Capital provides a good explanation as to why an investment strategy is important:

“To be a successful investor, you have to have a philosophy and process you believe in and can stick to, even under pressure. Since no approach will allow you to profit from all types of opportunities or in all environments, you have to be willing to not participate in everything that goes up, only the things that fit your approach. To be a disciplined investor, you have to be able to stand by and watch as other people make money in things you passed on.” ― The Truth about Investing, by Howard Marks

Back-testing allows you to develop a strategy which suits you. By running a back-test over many years, using stock selection criteria of your choice, you will build up a picture of how poorly, or otherwise, your strategy does over different periods of market history.

For example, to get an idea of how poorly your strategy might perform, you could run it from January 2008 through to March 2009 (i.e. the worst of the GFC). This is not to say that the exact same scenario will happen in the future – it won’t – but it does provide a useful guide, and will give you some indication of downside risk for the strategy you are creating.

Furthermore, you can test how to reduce risk. For example, you may wish to increase the diversification of your strategy by preventing your portfolio from holding more than 20% in any one industry. In addition, you can diversify your portfolio by position size, and test the difference between holding a 20-stock portfolio and a 100-stock portfolio with the same criteria. You may find that holding between 30 to 50 stocks is optimal.

By running a variety of scenarios, you will build up a picture of how your portfolio is likely to behave in the real world. This will give you an idea of expected risk and return. It will allow you to invest with more discipline, and importantly, accept some volatility which is par for the course when you are investing in the stock market. All in all, an investment strategy helps you to manage your portfolio as a whole rather than the sum of its parts.