EasyEquities Blog

What’s the Signal and What’s the Noise?

Written by TeamEasy | Nov 15, 2023 6:50:00 AM

Meet Jamie R. Paul, an EasyVSTR with a passion for investment risks. In his financial analysis honors thesis at Stellenbosch University, Jamie explores the world of long-term investments, offering insights on how investors can navigate its complexities. Plus, with two years of hands-on experience as an EasyEquities user, Jamie brings a practical perspective to the table.

Should investors go for short-term or long-term? Should they be invested for 3 or 5 years? What should they really be paying attention to? Get ready to read more about investment management through Jamie's journey and expertise!

"In 1720 one of the world’s smartest men, Sir Isaac Newton, sold his stake in the hottest English venture of the time, the South Sea Company, fearing its imminent collapse. He wryly remarked he could “calculate the motions of heavenly bodies but not the madness of the people.” A few months later, swept up in ‘exuberance’, he repurchased stock at a higher price - only to lose it all when the bubble finally burst. 

Open most finance textbooks and one soon learns that risk is proxied by the standard deviation, i.e. volatility: how much a stock varies, equals its risk.

Is volatility, however, the same thing as risk?
This divisive question is nothing new and was the subject of my Financial Analysis Honours thesis at Stellenbosch University. Since graduating, I worked in the start-up wine ecommerce world as a web developer and data analyst. Following my recent departure from this industry (unfortunately the company failed), I find my mind can’t resist wandering back to this question.

Respected investor Warren Buffett is vocal that risk is not volatility - a sentiment echoed by many so-called ‘value’ investors. On the other hand, classical academics like the late Harry Markowitz equated volatility as risk in Modern Portfolio Theory. This is the idea of constructing portfolios with the highest expected return but lowest possible risk, with ‘risk’ being the standard deviation.
However, at the end of the day, what investors are actually worried about is losing their money permanently – this is what keeps them up at night.

Risk is a difficult entity to proxy, and I’m cognizant one must try. I would posit that seeing risk as share price volatility will lead to poor investment decisions.

Take for a simple example the S&P500 Index - an index of around 500 of the largest American companies, each with a decent track record of positive earnings. This index will routinely replace companies that don't meet its criteria with ones that do.This index fluctuates dramatically. It has a high standard deviation. It swings and goes through extreme highs and extreme lows (sometimes lasting decades).



Is it risky though?
Looking at standard deviation, it surely is. However, upon research and some understanding of the index, I would suggest that it isn't risky… in the long term, at least.

To be invested in the S&P500 is to bet on the average economic results of the American economy (roughly speaking). This, I would say, is a pretty safe bet. Since beginning my investment journey with EasyEquities two years ago, I have chosen to only purchase into an S&P500 ETF.

However, the notion of time horizon is key. Stocks can fluctuate… wildly.But one can stomach big swings in the long term. It is definitely risky to have money in this index if you need money next month, next year or even in five years.

Benjamin Graham (one of Buffett’s original mentors) famously said, “In the short-run, the market is a voting machine but in the long run it is a weighing machine” i.e. in the short-term the market is opinionated and emotional whilst in the long-term the underlying qualities of a business are being reflected.

Over a long-time horizon, and with confidence in the underlying economics of the investment, short-term opinion and the swinging of the market should cease to worry the investor. And let’s face it’s the long haul that investors should entertain (as this where compound interest works its wonderful magic).

So, what's the solution?
What should one make of the standard deviation as a measure of risk? I propose one must be willing to accept there is a difference between volatility and risk. Sometimes volatility and risk overlap, sometimes they don't.

If one is investing in the long-term, then risk should always be centered on the investor's view of the underlying characteristics of the business, like competitive advantages such as Coca Cola’s secret formula or Apple’s tribal-like brand loyalty.

Generally speaking, the stock price and the business underneath it are loosely aligned in the short-term. For example, Amazon shares plummeted from $113 to $6 per share during the dot-com crash in the late 90s. According to the standard deviation the company’s risk was immense. However, Bezos noted that the company was actually in terrific shape (and growing fast) according to internal company metrics at the time. 

Bezos clarified by saying “the stock is not the company and the company is not the stock”. The message being that the share price is just an (often inaccurate) opinion of what’s actually going on within a business.

Value investors hunt for these kinds of opportunities where risk actually seems to decrease as a share price falls (i.e. taking advantage of what is deemed to be unjustified mispricing). In the aforementioned Amazon example shares were ‘discounted’, so to speak.

A public share price is in essence the average market opinion/prediction of how much free cash the company currently has, and how much it can produce in future. The question really becomes, how good or bad is the market (and humans in general, for that matter) at predicting things? 

Buffett once said the market is like a “drunken psycho” displaying a bipolar-like attitude, swinging from extreme optimism to wholesale pessimism. And neuroscience shows us humans have a remarkable overconfidence in their ability to make predictions. 

For example, the planning fallacy shows how we are far too optimistic about our ability to complete tasks. The Sydney Opera House was budgeted for $7 million - in the end it took 10 years longer and cost $102 million to complete. 

Additionally, the better-than-average-effect exposes our favourable optimism towards ourselves. Did you know that 80% of people think they are safer than the average driver? And that over 90% of college lecturers thought their teaching was above average? 18th Century philosopher David Hume shared with us the problem of induction – that using past data to extrapolate into the future can never actually be relied upon (…yet past data is basically what all forecasts are predicated on).

Ponder this: for 100 days a turkey is fed at the same time every day by a farmer. By day 100 the turkey has much prior data to confirm his belief that he will be fed again (his risk of death is at its lowest, from his perspective). Much to his surprise he’s killed for a thanksgiving meal! Little did he know his risk of death was actually at its highest by day 100. This is an example of Black Swan Theory, where prior observations tell us nothing about the future.

The message is that humans are overconfident in their ability to predict things. When a price moves, what proportion of that movement is legitimately justified and what proportion of it is unjustified? What’s the signal and what’s the noise? This debate (whether or not risk and volatility are the same) is, at its core, a debate around market efficiency – whether or not mispricing (from the ‘drunken psycho’) exists.

There is a tale about an economics professor and his student. Walking down the street the student notices a dollar on the ground and reaches to pick it up. The professor stops him and says, “Don’t bother, if it were real someone would have picked it up already”. 

It is up to the investor to decide how efficient they deem markets to be…

In summation, the investor should strive to be more agnostic to short-term price movements and most importantly, disregard standard deviation or any volatility-based risk measure for the most part, to succeed in their long-term investment management.

I would recommend the investor take a long time horizon (5+ years), question the efficiency and accuracy of markets and avoid being swept up in irrational exuberance as befell the learned Newton. 

The intelligent investor should rather pay attention to the underlying business characteristics that determine the company’s ability to earn cash profits in the long-term.

These will determine how risky the investment is.

And heed these two noble truths: don’t put too much faith in the human brain’s prediction software and always remember “the stock is not the company and the company is not the stock” (Bezos, 2018)."

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