Applying Artificial Neural Networks to Investment Analysis

Author(s): George S. Swales Jr. and Young Yoon

Source: Financial Analysts Journal, Vol. 48, No. 5 (Sep. - Oct., 1992), pp. 78-80
Published by: {cfa}
Stable URL: https://www.jstor.org/stable/4479584
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 Applying Artificial Neural Networks to Investment Analysis

George S. Swales Jr., forecasting abilities. Forecasts of
Associate Professor, Finance investment performance, based
on quantitative and qualitative
and General Business
variables, have achieved limited
Department, Soutbwest
success, although methodological
Missouri State University, and statistical problems remain.2
and The limitations of multiple dis-
Young Yoon, Assistant criminant analysis (MDA) suggest
Professor, Computer Infor- that an alternative, based on non-
mation Systems Depart- linear approaches, may better as-
ment, Southwest Missouri sist analysts and investors in mak-
State University ing decisions. Artificial neural
networks offer such an alterna-
tive.
Artificial neural network
technology can be used to A nonlinear artificial neural net-
work can address very complex
differentiate between stocks
problems.3 In particular, neural
that perform well and those net systems can accommodate
that perform poorly. This "fuzzy" or incomplete inputs,
note compares the neural hence may be particularly useful
network results with the to decision-makers dealing with
results of a more com- qualitative, rather than quantita-
tive, data. ANN techniques have
monly used linear multiple
outperformed regression meth-
discriminant analysis ap- ods in predicting bond ratings.4
proach. The non-linear, When applied to stock price be-
nine-variable, artifcial havior, however, the ANN tech-
neural network model per- nique has achieved only moder-
ate success to date.5
formed significantly better
than the tested alternative.
Multiple discriminant analysis
(MDA) has been used with quali-
(N
stock price appreciation) and
market valuation data from the
Fortune 500 and Business Week
"Top 1000" listing of firms.7 We
used two separate sets of data
from these sources. The first set
consisted of firms in the five in-
dustries from the Fortune 500
listings that offered investors the
highest total returns each year;
the sample consisted of 58 com-
panies. The second set consisted
of firms in the 10 industries re-
ported by Business Week to have
the highest market valuations; 40
companies were included in this
set.
We classified the firms in the For-
tune set into two groups accord-
ing to their total return. Group 1
firms provided investors with the
highest total returns in their re-
spective industries; Group 2 firms
provided the lowest returns in
their industries. We divided the
Business Week set of 40 firms into
two groups. Again, Group 1 con-
sisted of those firms with the
highest valuations for their indus-
tries. Firms in Group 2 had the
lowest valuations for their indus-
tries.

tative data to help forecast stock

This note addresses the applica- price performance. One piece of For each company, the study fo-
tion of an artificial neural net- qualitative information-the cused on the president's letter to
work (ANN) to investment analy- president's letter to stockhold- stockholders from the annual re-
sis. Specifically, can an ANN ers-provides valuable informa- port for the period immediately
differentiate between stocks that tion that is often overlooked by prior to the group-selection year.
LU
perform well and those that per- investors. This study uses the data Content analysis was used to
H form poorly? If so, how do the compiled from the president's classify and tally recurring themes
ANN's results compare with the letter to determine if an ANN can identified by similar words or
results of a commonly used mul- differentiate between firms phrases. The themes included ref-
tiple discriminant analysis ap- whose stock performed well and erences to confidence, economic
z
proach? those that performed poorly.6 factors, growth, strategic plans,
The study also compares the ANN new products, anticipated losses,
-J Multivariate discriminant analyti- technique's results with those of anticipated gains, long-term opti-
z
cal techniques such as bankruptcy more familiar multiple discrimi- mism and short-term optimism.
prediction, credit scoring of loan nant analysis. We used the frequency of allu-
z applicants and bond rating analy- sions to each theme and the per-
sis are commonly used in finan- The Study centage of the letters devoted to it
cial management.' These tech- In the original study, we com- to construct the data set. The fre-
78 niques have improved managers' piled total returns (dividends and quency data set was then used by

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 Figure A An Artificial Neural Network Model to Predict Stock Price Performance
Confidence
Economic Factors
Growth
Strategic Plans Well Performing Firms
New Products
Anticipated Losses Poorly Performing Firms
Anticipated Gains Hidden Units
Long-Term Optimism
Short-Term Optimism
Input
Units
both MDA and ANN techniques to
predict stock price performance.
We used the Statistical Analysis
System (SAS) step-wise discrimi-
nant procedure to develop a
nine-variable linear discriminant
analysis function. Discriminant
analysis techniques were used to
classify a set of independent vari-
ables into two or more mutually
exclusive categories. The ap-
proach involves finding a linear
combination of independent vari-
ables that reflects large differ-
ences in group means.
We developed a multilayered
ANN model to predict stock price
performance. We looked at three
different network architectures-
two-, three- and four-layered net-
works. A two-layered network has
only an input layer and an output
layer; an input unit on the input
layer has direct connections to an
output unit on the output layer. A
three-layered network consists of
an input layer, an intermediate
layer (called a hidden layer) and
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an output layer. An input unit has
connections to a hidden unit in
the hidden layer, and the hidden
unit has connections to an output
unit in the output layer. An input
unit in this network structure.has
indirect connections to an output
unit through hidden units. Hid-
den units augment the input data
in order to support any non-
linear function from input to out-
put units.
In an ANN model, a set of connec-
tion weights represents a function
from input to output. The pro-
cess of computing appropriate
weights is called "learning" or
"training"; it is equivalent to
Table I Nine-Variable MDA and ANN Models
Training Data Testing Data
Model Group 1 Group 2 Mean Group 1 Group 2 Mean
MDA 72% 76% 74% 70% 60% 65%
2-Layer ANN 63 65 64 65 40 52
3-Layer ANN 86 79 83 90 50 70
4-Layer ANN 86 96 91 90 65 77
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Glossary
*' Content Analysis:
Systematically classifying data
by counting and coding simi-
lar and recurring words or
phrases in order to analyze a
message's content. The cur-
rent study analyzes the presi-
dent's letter to stockholders.
"model building" in a statistical
environment.
The network we used (see Figure
A) has nine input units in the
input layer and two output units
in the output layer. Each input
layer represents one of the nine
independent variables and each
output unit represents one of two
possible outcomes-good stock
price performance or poor stock
price performance. The Business
Week group of companies formed
the training set for the network,
while the Fortune group formed
the testing set.
Results
Table I summarizes the perfor-
mances of the MDA and the two-,
three- and four-layered networks
on the training and testing data
sets. The Business Week nine-
variable MDA (training) model
correctly classified 21 of 29 com-
panies (72%) into Group 1 and 22
of 29 companies (76%) into
Group 2. However, for the For- a.
tune (testing) data set, the MDA C.'
model yielded an overall 65% 0
success rate; it correctly classified U
14 of 20 companies (70%) and 12 0
&
of 20 companies (60%) into
Groups 1 and 2, respectively. LU
LUI
The nonlinear nine-variable ANN
model did significantly better. z
D
-J
 The performance of the ANN
model also improved as the num-
ber of hidden layers was in-
creased. As Table I shows, a two-
layered network with no hidden
units yielded only a 52% success
rate, while a four-layered network
improved performance to 77%.
This study did not look at net-
works with more layers, since
four layers have been shown to
be sufficient to solve a problem if
a solution exists.
During the training phase, three
of the four models provided bet-
ter predictive capability for firms
in the lower performance cate-
gory than for firms in the higher
performance category. During
the testing phase, however, all
models demonstrated better pre-
dictive capability for firms in the
higher performance category.
The performance of the two-
layered ANN was not as good as
the performance of the MDA
model. A nonlinear output func-
tion was not useful in this ANN
application. The three-layered
ANN model, however, outper-
formed the MDA model by 9% for
the training data set and by 5% for
the testing data set. More impor-
tantly, the mean success rate dur-
ing the testing phase for the four-
layered network was 77%,
compared with 65% for the MDA
technique.
rsJ
Conclusion
LU
The ANN approach used in this
study was able to discriminate
0
between stocks that did well and
UJ
those that did poorly in the mar-
ketplace. It also outperformed the
LU
MDA approach overall.
LU
ing," Financial Analysts JournaL No-
LU vember/December 1990.
Investors who use ANN technol-
6 The original data set formed the ba-
ogy should be able to enhance
z sisfor G. Swales, Jr., "Another Look
their analysis of investment alter-
at the President's Letter to Stockhold-
natives. However, further re-
-J search into ANN techniques
needs to be done. Testing quanti- 7.
z tative and qualitative data, using
-J various time periods and looking
at different industries may further
U
z
validate the ANN technique and
4
its use in investment analysis. At
this early stage of development,
80 investors and researchers alike
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should seriously consider the ap-
plication of artificial neural net-
work techniques to investment
analysis.
Footnotes
1. See, for example E Altman, "Finan-
cial Ratios, Discriminant Analysis
and the Prediction of Corporate
Bankruptcy," Joumal of Finance, Sep-
tember 1968; R Collins, "An Empiri-
cal Comparison of Bankruptcy Pre-
diction Models," Financial
Management, Summer 1980; 0. Joy,
andj Tollenfson, "On the Financial
Application of Discriminant Analy-
sis," Journal of Financial and Quanti-
tative Analysis, December 1975.
2. R. Eisenbeis, "Pitfalls in the Applica-
tion of Discriminant Analysis in
Business Finance and Economics,"
Journal of Finance, June 1977; G.
Pinches, "Factors Influencing Classi-
fication Results from Multiple Dis-
criminant Analysis," Journal of Busi-
ness Research December 1980; E.
Scott, "On the Financial Application
of Discriminant Analysis: Comment,"
Journal of Financial and Quantitative
Analysis, March 1978.
3. T Kohonen, "An Introduction to
Neural Computing," Neural Net-
works 1 (1988), pp. 3-16; P. K Simp-
son, Artificial Neural Systems: Foun-
dations, Paradigms, Applications and
Implementations (New York: Perga-
mon Press, 1990).
4. S. Dutta and S. Shekhar, "Bond Rat-
ing: a non-conservative application
of neural networks," Proceedings of
the IEEE International Conference
on Neural Networks, pp. II443-
II450; A. J Surkan, andJ C. Single-
ton, "Neural Networks for bond rat-
ing improved by multiple hidden
layers," Proceedings of the IEEE In-
ternational Conference on Neural
Networks, pp. II157-Ill62.
5. D. Hawley, J Johnson and D. Raina,
"Artificial Neural Systems: A New
Tool for Financial Decision-Mak-
ers," Financial Analysts Journat
March/April 1988.
"The Fortune 500," Fortune, April
30, 1984, April 29, 1985 and April
28, 1986; "The Top 1000: America's
Most Valuable Companies," Business
Week April 18, 1986.
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