What will the Fed do next? How will conflict in the Middle East impact the oil price? What does a new bout of stimulus mean for the Chinese Equity market? Is the US economy heading into a recession or reflation? Investors are trapped in a vortex of noise. We are compelled to engage with and react to a rotating cast of inescapably prominent and impossibly complex issues. This constant state of flux is the lifeblood of the investment industry but poison for clients. For most investors 99%, of what we see, hear and feel in financial markets is not just irrelevant to what we are trying to achieve, it actively makes it harder to make good decisions and attain our goals. Why is noise so ubiquitous and what can we do about it?

Critical to the success of any investor is the ability to cancel out the noise that surrounds us and focus on the elements that will have a material influence on our outcomes. Given the sheer complexity and chaos inherent in financial markets this can seem like an impossible task – how can we figure out what is significant?

There are two key criteria we can apply to help us identify harmful noise in financial markets (which is the vast majority of what we encounter). For any issue or event, we should ask two questions:

– Does it matter?

– Is it knowable?

Unless we can answer both in the affirmative, we can classify it as unhelpful noise.

Let’s take each in turn:

– Does it matter? Here we are seeking to understand whether the subject we are focusing on will actually matter to what we are trying to achieve. Let’s assume I have a 20-year investment horizon, will the next decision by the Fed have any obvious impact on my investment goals? Absolutely not. The same can be said for whatever geopolitical issue is the focus of our attention at any given point in time. If something is likely to have either no effect or a random influence on us meeting our investment objectives, then it is just noise. Spending time thinking about it is likely to leave us worse off. 

Even if something does matter – we are confident that some variable or topic will have a material impact on our investments over the time horizons that matter to us – it can still be noise, because it also must be knowable.

– Is it knowable? Being confident that something actually matters is a pretty high hurdle for investment information, but even that is not sufficient. For it not to be noise, it must be knowable or predictable. Why? Well, let’s say I was certain that the near-term decisions of the Fed or the latest geopolitical issue would have an impact on meeting my investment objectives – this is only meaningful if I know or can predict the outcome of these things. I need to know both that the Fed decision matters and believe that I can predict it, otherwise, what am I going to do about it?

If that isn’t tough enough, there is another problem. We often need to know two things – both what is going to happen and how it will impact financial markets. Many wonderful (lucky) predictions about a particular event have been rendered worthless because someone got the second part wrong. Forecasting any future occurrence is usually a herculean task, adding on a prediction of how it will then influence something else (alongside all the other unforeseeable things that might also impact it) is getting us pretty close to impossible.

So, how can we tell what matters and what is knowable? Well, we can apply some simple tests.

Does it matter?

Test: If I had a crystal ball and knew something would occur in advance, would it change my investment decision making?

This is a useful test for long-term investors because most things really should not influence our choices. There is a danger, however, of being overconfident and believing that certain pieces of information will move markets in an obvious way. Imagine having some foresight of 2020 ‘Covid’ economic data and making investment decisions based on that – it probably would have ended badly.

Is it knowable?

Test: Is the information already known or is there evidence that people can accurately predict it?

The most obvious piece of information that is in some way knowable is the valuation of an asset. For example, when bond yields were close to zero we didn’t need to make predictions about future returns being low – we knew this. Unfortunately, most financial market relevant activity isn’t knowable, it is instead reliant on making bold predictions about the future, which in complex adaptive systems is quite the ask.

Bringing these aspects together creates a simple framework for addressing the issue of noise in financial markets and the many problems it causes investors: 

When people talk about current hot topics in financial markets – usually in wildly overconfident ways – we should be trying to apply this framework before anything else. Ask does the thing being discussed have any relevance based on my objectives and horizon, and if it does, is it reasonable to believe that it is in anyway knowable or predictable? The vast majority of things we can ignore, some things matter but are unpredictable so we diversify our portfolios, and a select few things really matter and should inform the investment decisions we make.

It is fair to say that what matters depends on the individual investor and what they are trying to achieve. So, for short-term traders many more events and occurrences will seem to matter because they are trying to judge near-term changes in sentiment. It is expected that they will interact with the market more than those with a longer horizon. The problem for investors taking such short-run perspectives is that most of the variables that might matter for them are not predictable in any reasonable or consistent way.

Using this framework leaves something of a puzzle, however. Most investors have long-term objectives, yet almost everyone seems to be obsessed with perpetuating short-term noise – constantly talking about things that don’t matter and / or are unknown and unpredictable. What causes such a dynamic? There are many, many factors at play, but here are a few ideas:

We want to reduce uncertainty: As humans we abhor uncertainty, and there are few things more uncertain than short-term financial market fluctuations. Engaging with what is happening and listening to people who confidently explain it (and predict how it will develop) is incredibly comforting. The sense of security it gives us is entirely false, but it feels real.   

We react to what is in front of us: Even if we try to avoid it, we are surrounded by news of what is unfolding right now and cannot help but think that what is happening in the moment is more important than anything else. 

We want to sound smart:  Talking about financial markets makes us sound smart. We can quite easily be wrong about how every major financial market event unfolds yet still sound credible and intelligent whilst doing it. The alternative is to say “I don’t know” or “it probably doesn’t matter” and that doesn’t do wonders for our conversations or career.

We don’t want to look negligent: One of the real challenges faced when trying not to engage with market noise, is that there will always be some events that will have an impact and matter (particularly in the short-run). We won’t know what these are beforehand, but after they occur everyone will act as if they were obvious and inevitable. We cannot risk looking negligent, so it is safer to treat everything as if it might be vital.

We avoid feedback: Does anybody genuinely keep track of the views they have on market events and short-term market moves? Almost certainly not. Everyone knows why this is, but it doesn’t matter because everyone carries on in the same fashion. ‘I was wrong yesterday and the day before that, but I will be right tomorrow.’

We focus on what matters to others: Unfortunately, it is not the things that matter to our long-term outcomes that are most important, but what other people think matters. If everyone else in the industry treats certain events or issues with the utmost significance, it is almost impossible to be an outlier. The industry acts as if these things are important, so clients think they are important, and it is rational to conform.

We want to sell something: Everything always in the end comes down to incentives. Noise, news flow and the conveyor belt of market events grease the wheels of almost everything that happens in the industry. It is in the interests of everyone to join in (apart from the clients).

We are bored: The willingness of investors to engage with market noise always reminds me of a social psychology experiment where participants were left alone in a room for fifteen minutes. They could either sit and think, or press a button that would give them an electric shock. 67% of men chose to electrocute themselves. Long-term investing is usually dull, embracing the noise of financial markets might be painful, but at least it stops us being bored.

—

I often wonder whether the majority of people involved in the investment industry know that much of what is discussed and debated on a day-to-day basis is often irrelevant and almost always unpredictable, and just play along with the game, or if they actually believe that they stand apart from everyone else in their ability to make sense of the cacophony. Whatever the case, noise is a real problem for most investors and one that can lead to poor long-term outcomes unless we find ways to drown it out.

The next time you get drawn into a conversation about the latest market event try stopping yourself and first asking – does this matter and is it knowable? The answer will usually be no. 

–

My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).