Hybrid quantitative and qualitative equity strategies based on behavioral finance can benefit from an understanding of irrational behavior and avoid mistakes rooted in illogical behavior. On top of that, these strategies can exploit opportunities by applying screens and models based on emotionally driven behavior.
J.P. Morgan Asset Management’s U.S. Behavioral Finance group uses quantitative models to screen a large investment universe and quickly rank stocks based on certain criteria. Then a team of qualitative research analysts interprets and evaluates these rankings, applying additional insights that the quantitative models might not have captured.
Behavioral finance concepts that are identified and captured through quantitative screens include:
- Recency Effect: Investors buy and sell stocks based on short-term fluctuations.
- Herd Behavior: Individuals in a group act together without questioning the group’s behavior.
- Overconfidence: Individuals think they are better investors than they are and underestimate risks.
- Confirmation Bias: Investors use a form of selective thinking, seeking out information that supports their preconceived opinions, and ignoring information that contradicts them.
- Anchoring: People tend to under react to new information and adjust their earlier beliefs to a lesser degree than is warranted by the new information.
The hybrid process begins with three factor-buckets used to rank stocks: value, momentum, and quality. These relate to many of the behavioral finance concepts. For example, momentum applies the Herd Behavior and Anchoring behavior, while value takes information from the Overconfidence and Recency Effect screens that indicate mispricings.
By combining the breadth of view provided by quantitative investing with the depth of view arrived at through qualitative investing, this hybrid approach uses the best of both worlds to arrive at deeper and broader insights on stocks.