Signal and Noise

Signal and Noise

I try and play bridge once a week, last week the tournament start was delayed due to an election rally which caused a traffic jam. I was chatting with one of the senior bridge players, when he found out about my line of work he said “I invested in stocks long time ago, the prices keep moving up and down, I was never able to figure out when to buy and sell, I lost a bit of money and then lost all interest in equity investing”. I hear this or a similar version many times and see that the person’s primary focus was the stock price and its fluctuation creates a certain level of discomfort.

Few weeks ago, I was talking to a person who runs a listed company, he was amused that it took a large effort and long time to increase the profitability of the business by a few percentage points, but the stock market would have that kind of a fluctuation on a daily basis. He was not sure if the stock market “understood” that there is no way the fortunes of his firm can change from a day to a day basis, leave alone the minute to minute fluctuations.

An interesting allegory created by Ben Graham of a manic depressive Mr Market, who is constantly giving quotations for buying or selling the business based on how Mr Market felt at that moment. Ben Graham wrote that Mr Market should be largely ignored and sometimes should be taken advantage of (when Mr Market’s mood swings take him far away from the ground reality). Ben Graham also said that market is a voting machine (led emotions/rumors) in the short run but a weighing machine (led by logic and numbers) in the long run.

Businesses all over the world have created tremendous value by offering goods and services that are valued by their clients. This value created is inevitably reflected in the valuation/share price of the business in the long run, but it is very difficult to explain their short term fluctuations.

Albeit there are enough shenanigans (especially on TV) who help create a lot of noise. Their personal financial futures depend on their ability to show that they have an expertise in reading the tea leaves. For a large part they are like the commentators in the ball park, who believe that they understand the game better than the players and also believe that their commentary has significant impact on the game. Prudent investors would be best served if they ignore these shenanigans.

Investors should remember that by buying a stock they are becoming business owners, and growing a real business is a gradual process which takes time. Management actions can not alter the value of a business on a minute to minute basis, but management can definitely influence the value of the business in the long run.

One can say that in an investment world

  • Signal: Ability of a business to create value for its customers and capture some of the value created as profits
  • Noise: Continual fluctuation in prices

Investors should be aware that there is a lot of noise in the market and the noise tends to make it very difficult for one to focus on the signal and interpret it. The art of investing is all about having a robust process for tuning out the noise and interpreting the signal.

 

Happy investing….


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About Praveen Reddy

http://in.linkedin.com/in/praveenreddyinduswealth

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