In the first full length Sherlock Holmes novel ‘A Study in Scarlet’ the brilliant detective’s sidekick, Watson, is staggered to discover that Holmes is apparently not aware that the earth revolves around the sun.[i] Watson cannot comprehend how an astonishingly intelligent individual can be ignorant of such basic facts. Holmes, however, explains that he actively disregards and forgets information that is not relevant to his detective work:
“A fool takes in all the lumber of every sort that he comes across, so that the knowledge which might be useful to him gets crowded out”.
Holmes’ approach provides a useful framework for investors. It is essential that we find a means of cancelling out incessant market noise if we are to behave in a manner that will allow us to meet our long-term goals.
For Holmes, skill is about our ability to focus singularly on the elements that are relevant to our task:
“Now the skilful workman is very careful indeed as to what he takes into his brain attic. He will have nothing but the tools which may help him in doing his work”.
Here Holmes is distinguishing between signal and noise. Noise, as defined by Daniel Kahneman, is where our judgements are “strongly influenced by irrelevant factors”.[ii] There is probably no field where noise or erroneous considerations impact our choices more than investment. The overwhelming majority of what we hear and see about financial markets is entirely inconsequential to achieving our objectives. It is just exceedingly difficult to accept this.
There are two forms of noise that matter to investors, which we can think of as conscious and unconscious noise:
Conscious noise is where we react or respond to information that we think is meaningful but is entirely redundant. Worse than that, the fact that we interpret it as some form of signal transforms it from being innocuous to damaging because it leads to poor behaviours. Take, for example, a long-term investor consistently checking the latest stock market movements or worrying about how some macro-economic event will impact their portfolio. There is no signal in this, nothing that can be used to better fulfil their aspirations, quite the contrary.
Unconscious noise arises in situations where our decisions are influenced by extraneous factors, but we have no awareness or acceptance that they have affected our judgement. The best examples of this are related to emotions; how we feel – pressurised, stressed, excited or fearful – can lead to wildly inconsistent choices through time.
The concern Holmes expresses on noise is around it’s propensity to obscure or overwhelm the insightful knowledge he holds or the mental models he wishes to use. Likewise, an investor might be applying a simple and effective set of models to meet their long-term needs – diversification, rebalancing, regular saving, and compound interest – yet this sensible framework can be torn asunder by the magnitude and force of market noise:
“Depend upon it there comes a time when for every addition of knowledge you forget something that you knew before.”
It is in treacherous market conditions – like those we are facing at present – where the potential for noise to wreck our investment intentions is most pronounced. Emotive and salient negativity will be inescapable, and it will seem negligent to ignore it. This not only risks us forgetting our best laid plans but questioning whether they are even still relevant.
As investors we not only need to ensure that we are able to focus on what matters and why, but we must be constantly on guard against the often-irresistible spectre of noise.
“It is of the highest importance, therefore, not to have useless facts elbowing out the useful ones”.
[i] Doyle, A. C. (1904). A Study in Scarlet. Harper & Brothers.
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