Are You Listening To The Signal Or The Static?

When I was in high school, I listened to baseball on the radio.  Joe Chrysdale and Hal Kelly on AM 580, CKEY told the story of the Toronto Maple Leafs baseball team.  Sparky Anderson played there in the early ‘60’s.  Who could forget Rocky Nelson?  He was a very good hitter, but the story was that he kept his glove in oil lest it get rusty.  Clang!

If there was no Leaf game, you could catch Harry Caray with the Cardinals on KMOX.  You could hear Gibson versus Koufax or Drysdale or Marichal, and follow Stan Musial at the end of his brilliant career.  You had to pay attention though, because listening to KMOX required that you ignore the static.

AM radio stations send a strong clear signal and the vagaries of the atmosphere and the receiver’s location interferes with it.  That is what static is.

Sort of like the stock market.

In the stock market there is a clear underlying value driver (the signal).  Obscured by short term variability (static)

The signal that results for a given security or even an index is a combination of things.  The economy, the business and its management, products, population growth, demographics, competitors, technology, brand.

If you track values of the S&P 500 since the early 1920’s, you will find the signal is almost exactly 10%.  The values tend to run in a trough between 9.8% and 10.2%.  It is moderately clear.  Values don’t stay far away for very long.  Year over year variations are seldom more than 3 times the size of the signal.  Most years lie between minus 20% and plus 40%

For 250 trading days a year, 10% annually is a bit less than .04% daily.  Looking at daily returns however, you find that you cannot see the .04% signal at all.  Static dominates.

There are days when the change has been more than 100 times the expected .04%.  There is one day when it was more than 500 times.  Yet, at the end of several years, the static all cancels and the underlying signal remains.

What does that mean?

  1. Most of the intense traders are trading noise not signal.  Day trading does not use investment rules for success even though it sometimes looks like they are.  It is hard to imagine how the static contributes information but I suppose, for a trader, it must.
  2. If you are an investor, as opposed to a trader, the static will be confusing.  Ignore it
  3. You will usually be upset with the stock market if you follow it too closely.  How so?  I should have less risk if I pay attention.

True if you are a robot.  Not so much for humans.

According to Nobel Prize winner Daniel Kahneman, people are about twice as upset over a given loss as they are happy for an equal sized gain.  To give yourself a chance of happiness, you should look at intervals where you are about twice as likely to see a gain as a win.  If you look at the market every day, the odds are about equal that you will see a loss or a gain.  Emotionally though, that is plus one and minus two.

I am sorry to say that I am not as fluent with math as I once was, and my awareness of the Central Limit Theorem is vague at best, but I think if you look at the stock market about once every 42 months you should expect to see positive results twice as often as negative results.

This will not and probably should not change your behavior, but at least you can console yourself that the market is working, just not today or this month, or however often you look.

Here’s the real defense to static.

Think about buying a small part of a business instead of buying a share.  They are exactly the same thing, but when you think about buying part of a business, the day-to-day variances are in context.  If instead, you buy a stock it is easy to fall into the volatility trap.  If the share price is the only thing you relate to, then the variability will be more apparent and thus more disturbing.

Warren Buffet buys businesses not stocks.  The difference from you is that he buys the whole or most of the business rather than a minute fraction of it.  He has said however, that he would not care if they closed the stock exchange for 10 years after he buys.  He seeks management, market position, products, techniques and people.  Day to day differences do not change those.

You might want to do the same or find a manager who does.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Follow on Twitter @DonShaughnessy

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