Applying Artificial Neural Networks to Investment Analysis

George S. Swales Jr., forecasting abilities. Forecasts of stock price appreciation) and
Associate Professor, Finance investment perfonnance, based market valuation data from the
on quantitative and qualitative Fortune 500 and Business Week
and General Business variables, have achieved limited "Top 1000" listing of firms.^ We
Department, Southwest success, although methodological used two separate sets of data
Missouri State University, and statistical problems remain.^ from these sources. The first set
and The limitations of multiple dis- consisted of firms in the five in-
Young Yoon, Assistant criminant analysis (MDA) suggest dustries from the Fortune 500
Professor, Computer Infor- that an alternative, based on non- listings that offered investors the
mation Systems Depart- linear approaches, may better as- highest total returns each year;
ment, Southwest Missouri sist analysts and investors in mak- the sample consisted of 58 com-
ing decisions. Artificial neural panies. The second set consisted
State University networks offer such an alterna- of firms in the 10 industries re-
tive. poned by Business Week to have
Artificial neural network the highest market valuations; 40
technology can he used to A nonlinear artificial neural net- companies were included in this
differentiate between stocks work can address very complex set.
problems.^ In particular, neural
that perform well and those net systems can accommodate We classified the firms in the For-
that perform poorly. This "fuzzy" or incomplete inputs, tune set into two groups accord-
note compares the neural hence may be particularly useful ing to their total retum. Group 1
network results with the to decision-makers dealing with firms provided investors with the
results of a more com- qualitative, rather than quantita- highest total retums in their re-
tive, data. ANN techniques have spective industries; Group 2 firms
monly used linear multiple outperformed regression meth- provided the lowest retums in
discriminant analysis ap- ods in predicting bond ratings. their industries. We divided the
proach. The non-linear, When applied to stock price be- Business Week set of 40firmsinto
nine-variahle, artificial havior, however, the ANN tech- two groups. Again, Group 1 con-
nique has achieved only moder- sisted of those firms with the
neural network model per- ate success to date.^ highest valuations for their indus-
formed significantly better tries. Firms in Group 2 had the
than the tested alternative. Multiple discriminant analysis lowest valuations for their indus-
(MDA) has been used with quali- tries.
tative data to help forecast stock
m This note addresses the applica- price perfonnance. One piece of For each company, the study fo-
O qualitative informationthe cused on the president's letter to
tion of an artificial neural net-
work (ANN) to investment analy- president's letter to stockhold- stockholders from the annual re-
sis. Specifically, can an ANN ersprovides valuable informa- port for the period immediately
differentiate between stocks that tion that is often overlooked by prior to the group-selection year.
I perform well and those that per-
form poorly? If so, how do the
investors. This study uses the data Content analysis was used to
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
a: results of a commonly used mul- differentiate between firms phrases. The themes induded ref-
tiple discriminant analysis ap- whose stock performed well and erences to confidence, economic
t; proach? those that performed poorly. factors, growth, strategic plans,
The study also compares the ANN new products, anticipated losses,
z Multivariate discriminant analyti- technique's results with those of anticipated gains, long-term opti-
f cal techniques such as bankruptcy more familiar multiple discrimi- mism and short-term optimism.
0 prediction, credit scoririg of loan nant analysis. We used the frequency of allu-
5 applicants and bond rating analy- sions to each theme and the per-
1 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 construa the data set. The fre-
78 niques have improved managers' piled total retums (dividends and quency data set was then used by
 Figure A An Artificial Neural Network Model to Predict Stock Price Performance Glossary

^Content Analysis:
Confidence Systematically classifying data
by counting and coding simi-
lar and recurring words or
Economic Factors phrases in order to analyze a
message's content. The cur-
Growth rent study analyzes the presi-
dent's letter to stockholders.
Strategic Plans Well Performing Firms

New Products "model building" in a statistical

environment.
Anticipated Losses Poorly Performing Firms
The network we used (see Figure
Anticipated Gains
Output A) has nine input units in the
Units input layer and two output units
in the output layer. Each input
Long-Term Optin[iism
layer represents one of the nine
independent variables and each
Short-Term Optimism output unit represents one of two
possible outcomesgood 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
both MDA and ANN techniques to an output layer. An input unit has Table I sutnmarizes the perfor-
predict stock price performance. connections to a hidden unit in mances of the MDA and the two-,
the hidden layer, and the hidden three- and four-layered networks
We used the Statistical Analysis unit has connections to an output on the training and testing data
System (SAS) step-wise discrimi- unit in the output layer. An input sets. The Business Week nine-
nant procedure to develop a unit in this network structure has variable MDA (training) model
nine-variable linear discriminant indirea connections to an output correctly classified 21 of 29 com-
analysis function. Discriminant unit through hidden units. Hid- panies (72%) into Group 1 and 22
analysis techniques were used to den units augment the input data of 29 companies (76%) into
classify a set of independent vari- in order to support any non- Group 2. However, for the For-
ables into two or more mutually linear function from input to out- tune (testing) data set, the MDA
exclusive categories. The ap- put units. model yielded an overall 65% m
proach involves finding a linear success rate; it correctly classified O
combination of independent vari- In an ANN model, a set of connec- 14 of 20 companies (70%) and 12
ables that reflects large differ- tion weights represents a function of 20 companies (60%) into
ences in group means. from input to output. The pro- Groups 1 and 2, respectively.
cess of computing appropriate
We developed a multilayered weights is called "leaming" or The nonlinear nine-variable ANN
ANN model to predict stock price "training"; it is equivalent to model did significantly better.
performance. We looked at three
different network architectures g
two-, three- and four-layered net- Table I Nine-Vadable MDA and ANN Models
works. A two-layered network has
only an input layer and an output Training Data Testing Data
layer; an input unit on the input Model Group 1 Group 2 Mean Group 1 Group 2 Mean
layer has direct connections to an
MDA
output unit on the output layer. A 2-Layer ANN 72% 76% 74% 70% 60% 65%
63 65 64 65 40 52
three-layered network consists of 3-Layer ANN 86 79 83 90 50 70
an input layer, an intermediate 4-Layer ANN 86 96 91 90 65 77
layer (called a hidden layer) and 79
 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 ihc MDA
technique.
Condusion
The ANN approach used in this
study was able to discriminate
e
CO
between stocks that did well and
9 those that did poorly in the mar-
a: ketplace. It also outperformed the
MDA approach overall.
Investors who use ANN technol-
ogy should be able to enhance
a: their analysis of investment alter-
O natives. However, further re-
search into ANN techniques
I needs to be done. Testing quanti-
tative and qualitative data, using
various time periods and looking
at different industries may further
validate the ANN technique and
its use in investment analj^is. At
this early stage of development,
80 investors and researchers alike
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," Journal of Finance, Sep-
tember 1968; R. Collins, "An Empiri-
cal Comparison of Bankruptcy Pre-
diction Models," Financial
Management, Summer 1980; O. Joy,
andj. Tollenjson, "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-
aiminant Analysis," Journal of Busi-
ness Research, December 1980; E.
Scott, "On tbe 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. Sbekbar, "Bond Rat-
ing: a non-conservative application
of neural networks," Proceedings of
the IEEE Intemationai Conference
on Neural Networks, pp. 11445-
11450; A /. Surkan, andJ. C. Single-
ton, "Neural Networks for bond rat-
ing improved by multiple bidden
layers," Proceedings of the IEEE In-
ternational Conference on Neural
Networks, pp. 11157-11162.
5. D. Hawley, J. Johnson and D. Raina,
"Artificial Neural Systems: A New
Toolfor Financial Decision-Mak-
ing, " Financial Analysts Journal, No-
vember/December 1990.
6. The origjnal data set formed the ba-
sis for G. Swales, Jr., "Another Look
at the Presidents Letter to Stockhold-
ers, " Financial Analysts Journal,
March/April 1988.
7. "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,