Wednesday, August 20, 2008

The Less You Read Newspapers and Watch TV, The Better Off You Are

That may seem counterintuitive, but in fact it is absolutely true. Fischer Black's seminal paper about market noise, written in the 1980s, gives a stellar explanation about this phenomenon (Journal of Finance, Vol 41, pgs 529-543). Noise represents large number of inconsequential events. This is contrasted with information, which relates to small number of significant events. People in general mistake one for the other, and thus make decisions that can ultimately lead to disastrous consequences--or alternatively to serendipitous results. Therefore "noise is what makes our observations imperfect. It keeps us from knowing the expected return of a stock or keeps us from knowing what, if anything, we can do to make things better." In this day and age, what will separate the relative success of one person from another will be predicated on the quality of information, not noise disguised as information. If you have ever walked in a securities trading floor, you will notice impressive databases that provide instantaneous information; much of it, however is simply noise. Traders undoubtedly will make buy and sell decisions supported by what they abstracted from these databases. This is the foundation that supports the view that daily stock price movements embody a voting mechanism. That is, market participants will buy/sell a stock as if casting a vote on the perceived price for a given amount of information (which is really noise).

I equate "noise" to the unfortunate human activity of gossip: There's a lot of it going around, but few of it deserves worthy consideration. However, people generally treat all gossip as credible information and act accordingly based on it. For the average person, irrespective of his or her condition (i.e. wealthy or poor), distinguishing noise and information can be a daunting task. As a result they will tend to gravitate to the "path of least resistance"; that is, to take whatever flashes in a screen from a "reputable" entity as reliable, without actually checking its veracity. Newspapers and television are primary culprits of disseminating it to the general public; so it is best for individuals to stay away from them as much as possible. I believe it is noise the fire that starts euphoric sentiments in the market. In other words, panic selling or ecstatic buying has its roots in discernment from this misinterpreted data. As a result, we become someone, as John Locke said, "reasoning correctly from erroneous premises." This analysis not only applies to stock markets but also to a wide array of human activity.

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