One of the pervasive risks that we face in the digital age is that even as the amount of information in the world is increasing, the gap between what we know and what we think we know may be widening. This means the ability to separate noise from signal is of increasing importance.
Signal or noise?
In science, algorithms do a great job in separating signal from noise. For example, the separation of music signals is an interesting and challenging problem. Since the harmonic structure of a music signal is stable, harmonic structure modelling and algorithms can do an excellent job in separating signals and obtaining a very high Signal-to-Noise Ratio (SNR). It’s a much different story in the investment world where stability and equilibrium are only theoretical concepts! Without underlying stability, algorithms are unlikely to be of much help in reducing the Signal-to-Noise Ratio. Separating signal from noise is a much more challenging task in investments.
Nate Silver has a good quote on this. In his book: "The Signal and the Noise – Why so many predictions fail, but some don’t" he highlights:
Distinguishing the signal from noise requires both scientific knowledge and self-knowledge: the serenity to accept the things we cannot predict, the courage to predict things we can, and the wisdom to know the difference.
So many people fail in investments because they persist to predict and bet on what can’t be predicted. And with an ever-increasing amount of information available, the temptation to forecast is even greater. The danger in investing based on forecasts is that we end up selling low and buying high.
Case in point, not long ago as we entered 2020 and markets were at all-time highs, stocks analysts were busy revising up their price targets, fast forward a couple of months and after some sharp market falls, we are seeing the mirror image with analysts busy revising down their target prices. It is true that when facts change, they change their mind, but unfortunately when everyone can see facts have changed, then it’s too late and it’s priced in.
How to avoid the traps of fear and greed
Here are some key principles that we think investors should follow in order to reduce the risk falling in the emotional trap of reactive investing:
- Not sacrificing information processing for information gathering (a wealth of information [without the appropriate processing power] creates a poverty of attention);
- Focusing on the things we can control while mitigating the impact of things we cannot. Mistaking the two can often lead to disastrous results. In market terms, the fact that long term valuations are high and prospective returns are low is given. This is the hand we have been given and we can’t change that. What we can do is to adapt our investment approach given the limitations on prospective returns.
- Playing the game we were set out to play. If we start taking cues from people playing a different game than we are, we are bound to be fooled and eventually become lost, since different games have different rules and different goals. Few things matter more with money than understanding our own time horizon and not being persuaded by the actions and behaviours of people playing different games.
- Putting risk management at the heart of our investment decisions and making a clear distinction between risk and volatility.
- Volatility is an unexpected deviation in the path to destination (i.e. the investment goal) which can lead to both risks and opportunities. Risk is the probability of not reaching the destination (failing to achieve the investment objective). Volatility can lead to a credible risk of sustained shortfall if it takes away one’s choice and available options. This is why leveraged strategies are incredibly risky during volatile times.
- A leveraged investor can be stopped out of a position without the option (i.e. funds) to participate in the upside. Similarly, a short-term investor without the option of time who is forced to liquidate positions in response to volatility is likely to be subjected to increased risk of shortfall.
- Risks are often hidden where not many people are looking for (hence the term risk!) Volatility is a backward-looking reactive measure which is often triggered in response to a wider recognition of risks. The best place to look for risk is within the “crowd”. Crowded positions; crowded investment strategies or investment styles all entail a significant risk of failure. We can talk so much about smart beta, factor diversification, managed volatility funds etc., but when crowded, smart beta can be dumb beta, factor diversification can provide no diversification and managed volatility funds can end up being highly risky funds.
- In fact, the proliferation of managed/low or capped volatility funds is now resulting in frequent outbreaks of short term volatility as these strategies respond to the same market dynamics at the same time (in simple terms, sell equities when volatility goes up and buy when volatility goes down). In a world so obsessed with managing short-term volatility, perhaps smart money should move in the opposite direction to these widely embraced strategies.
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