Cancel Out The Noise
What do we have in common with investors? We evaluate our performance a little too often. Read on to understand why I think this is bad, and what I did to make a change.
This is the second in a series of posts about how we can apply lessons from the stock market to our daily lives. In my first post, I made a case for why diversification, a risk minimization strategy, is as relevant in our personal lives as it is in our investment portfolios. I ended the blog with an unsolicited recommendation - evaluate your happiness portfolio.
Evaluating your portfolio is important, not only in the markets but also in life. But most stock market investors -- not day traders -- tend to check the performance of their portfolio too often, every day if not every hour. Most successful investors and behavioral economists, including Warren Buffet and Richard Thaler, strongly advise against this habit. If you are in it for the long run, tracking your progress on an hourly or daily basis causes unnecessary stress and negative emotions.
There are many reasons why we shouldn't constantly monitor the markets and stock prices, but today I am going to focus on one of them - randomness.
Nassim Nicholas Taleb, in his book Fooled By Randomness, explains it best:
"There is a happily retired dentist, living in a pleasant sunny town who has a15% return with a 10% volatility (or uncertainty) per annum which translates into a 93% probability of success in any given year. But seen at a narrow time scale, this translates into a mere 50.02% probability of success over any given second."
What does that mean? 95 out of a 100 times, the dentist will make anywhere between 5% and 35% on his investment. Or, in any given year, the dentist has a 93% chance of making some money. But, at any given second within the year, the probability that the dentist will make money is about 50%. That means that the performance of the dentist's portfolio at any given second is as good as random.
There is a 50-50 chance that the dentist, who is constantly monitoring his progress, will have a portfolio that is in the green, no better than a coin toss. Randomness is scalable. This means that in the short run you observe more noise than true trends. During the hourly check-ins, the dentist is noticing the volatility in returns and not the true performance of his portfolio. A few more numbers to make that stick. In an hour, the ratio of noise to the actual performance that we see is about 30 to 1. In a year, that ratio changes to 0.7 parts noise for 1 part of performance.
Enough with the finance and numbers. What's this got to do with real life? A lot, actually. After I wrote about diversification, I noticed that while I hadn't considered how diversified my happiness portfolio was, I was guilty of constantly tracking its performance. I may not have a Bloomberg app like an investor, but my brain readily provides notifications about whether I am in the red or the green.
I notice that my best friend has been acting strange. Oh no, I'm in the red there. Am I investing too much in this friendship? I see a few failed empirical results while writing my thesis and question whether it will ever be a net-positive investment of my time. And almost every other day, I evaluate my daily run and convince myself that my new goal of running a marathon is a pipe-dream. Time to sell this goal? I feel like I am not alone. We all evaluate the returns on the things we invest our time in a little too often. And when we do, more often than not we end up unhappy and less motivated to continue investing our time and pursue our goals.
I am no different than the retired dentist. At any given hour that I choose to evaluate the returns on my portfolio, I too am subject to the 30 is to 1, noise to performance ratio, irrespective of how diversified I am. When I see a change in my happiness, I am most likely observing the randomness and volatility that is inherent in everyday life. I am viewing my friend's behavior, which may be the result of a bad day or personal struggles, as the intrinsic value of our friendship when it is simply noise. I am considering my daily variation in running speed, which may be a function of weather, sleep, or a hundred other random factors, to be a measure of my intrinsic ability to be a good runner.
Buffett and others don't recommend constantly monitoring your portfolio because daily exposure to that high a level of randomness, which is misconstrued for returns, leads to stress and emotional swings.
Their solution is to turn off the notifications on your stock app. If only I could do the same with my brain. While I can't turn off my brain's notifications, I can choose to evaluate what being in the red actually reflects - is it a change in the intrinsic value of my happiness portfolio or is it simply noise? For the investments that I've had for a long time, like friendships and goals, all I have to do is zoom out a little. If I look back at how much I've received and how far I've come, I am able to see the actual returns rather than randomness. As for my new investments, like running, I put on some noise-canceling earphones and vow to check back in at the end of the quarter.