Are You Listening to Signal Or Static??Don Shaughnessy
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.
Sort of like the stock market.
AM radio stations send a strong clear signal and the vagaries of the atmosphere and the receiver’s location interfere with it. That is what static is.
In the stock market there is a clear underlying value driver (the signal) obscured by short term variability (static)
The signal for a given security is a combination of things. The national and global economy, the business and its management, population growth, demographics, competitors, technology, brand. The static is political comment, pundits, new and unproven connections, newspaper and TV stories, short term dominated thinking.
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 do not 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 roughly .04% daily. When you look at daily returns, the signal cannot be seen 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?
- Most of the intense investors are trading on noise not signal. Day trading does not use investment rules for success even though it sometimes looks like they do. Day traders are trading the static.
- 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 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. Emotion leads to weaker decisions.
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 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 as it should, just not today or this month, or however often you look.
When you buy shares, you buy part of a business. Thinking business instead of stock will help you see the day-to-day variances in context. When instead, you think share price, it is easy to fall into the volatility trap.
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 that he would not care if they close the stock exchange for 10 years after he buys. He is seeking management, market position, products, techniques and people, and time does not change that.
You might want to do the same.
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. firstname.lastname@example.org