What is Quantitative Behavioral Finance?

The foundation of our equity modeling work is based on three principles:

1. Markets exist to accommodate different objectives. Buy-and-hold pension funds have different objectives than highly leveraged proprietary traders. Investment time horizons, directional bias, leverage and risk tolerance define specific patterned behaviors for each type of market participant.
2. Tops are different from bottoms. In equities tops tend to be a process and bottoms tend to be an event. This infers different models for buying and selling. The change in relative volatility is an especially important characteristic to differentiate tops from bottoms.
3. The information content of index constituents is greater than that of the index itself. The index (e.g. S&P 500) is best viewed as "noise" relative to the "signal" that can be extracted from aggregating information across constituents (e.g. all 500 stocks). Consequently, our models do not use the price of the index as a direct input; rather the model utilizes aggregate information based on the real-time analysis of each index constituent.

Long opportunities are best characterized as extreme “offsides” reversals between long-term and short-term market participants. This can take the form of long-term investors selling and short-term traders increasingly embracing net long positions. Profitable trading shorts become built-in buyers and can add substantially to volatility at important market lows. Long-only portfolio managers often behave like “trapped shorts” after an important market low if they are under-invested and their benchmark rallies; these behaviors reinforce and support the emergence of a new bull trend.

Short opportunities are often characterized by lower volatility/distribution environments where long-term investors slow their pace of buying (or stop altogether) and short-term traders become opportunistic. This takes time to unfold and has a different structure than long opportunities. The inverted "V" bearish reversal is rare and has the lowest profit probability. High-probability shorts are an unfolding and accelerating process.