December 27, 2012

Trading on noise

Mid-caps and small cap stocks have an average standard deviation of around 18-20% per annum. The implication of this factoid is that these stocks can drop or rise by 15%+ over a year for no fundamental reason at all.

Anecdotally most of us have seen a drop or rise in the stock price by 15% or more within a quarter, even in absence of any stock specific news. One can say that the stock price in such cases is being driven by noise.

What is noise?
In layman’s term, noise is variation without any underlying cause. In other words, the probability of the upside or downside is around 50%, which is the equivalent of a coin toss (random event). So if you expect a 15% variation due to noise, the probability of increase or decrease is the same with the expected value being zero ( expected value = 0.5*upside+0.5*downside)

Trading on noise
If your trading or investing strategy involves a 15-18% upside on the current price within a year, it is quite likely that the stock price may rise for no reason other than random fluctuations. In such a scenario, you may end up making money for no specific reason – though you may think that it was the result of your accurate analysis.

The risk of making money in such a way is that one ends up with the wrong conclusions, even though the real  cause of success was sheer luck (for further understanding of this phenomenon , you should read the book – fooled by randomness).

In addition to a faulty understanding, the long term returns can turn out to be sub par as the expected value for a series of such trades is essentially zero (upside and downside being equally likely).

Financial news is all noise
I am sure most of you have watched the financial news channels. Almost 90% of the time is spent on explaining the fluctuations during the day, which for the predominant part is just noise. Ofcourse you will get some information or insight if you spent the entire day watching this circus, but it is like chewing a ton of grass to get a litre of milk.

There are far more efficient and easier ways to get the required information – annual reports or magazine articles being some of them. One should watch these channels for entertainment and not for information.

Noise trading quite pervasive
If you think that trading or investing on noise is a rare occurrence, you may be mistaken. I am sure most of you would have seen analyst reports or talking heads recommend some stock with a 10-15% upside in the short to medium term.

If the random fluctuation of stocks is 15% or more, then some of the recommendations will achieve this upside for no reason at all. The unsophisticated investor would erroneously consider the analyst to be skilled at picking stocks and may start following such people or worse, even pay for such advise.

How to see through such tricks?
I will suggest a simple set of rules to ignore analysts and their stock picks if the following is true

-          A price target with a 15-20% upside within the year

-          A success rate of 55% or less in terms of success rate (preferably over a year)

-          Completely confident and sure of the picks (no allowance or probability of error)

Now, you may be thinking that the above is an unrealistic and harsh set of expectations. Let me ask you this – In your job or business, does your boss or customer give you a raise or money for being wrong more than 50% of the times?

As far as I know, if someone goofed up 20% of the times or more, he or she will be out of a job or business. Why should the expectations from an analyst be any lower?


Dev said...

One should only watch channels like CNBC & NDTV Profit to see the real beauty of stock markets ;)

Manufactured Luck said...

Hi Rohit,

Nice Post. Judging skill v/s luck in investing is a fascinating subject.

One way to judge confidence could be if an analyst were to share views on position sizing along with the attractiveness of any idea. So even if the expected gains are low, if the analyst can successfully argue a case for a large allocation, then it must be due to a favorable risk-reward equation and thus an outcome of skill as compared to luck. However, if the suggested allocation is weak as well as the expected reward small, then it is probably a case of a ‘monkey throwing darts’ and thus better ignored.

Would be great to hear your further views..

Akash Parmar said...

Wonderful words!

I read both of Taleb's books.However, not ignoring the brilliance of his observations, i had only one dissatisfaction with his premise.I did not understand the application of his dumbbell theory.I experimented with it , but couldn't get it right.

Could you please right an article on effective use of "out of money" put options?

Rohit Chauhan said...

Hi dev
atleast the presenter in your is pleasing to the eye :)

hi abhinav/ niren
good to have you here. i follow your blog quite closely. i have never seen analyst indicate the size of thier position ..atbest they will say that they are holding it which tells nothing. a 1% position will not matter either ways

compared to analysts i would prefer to listen to fellow investors who have skin in the game and would actually do a much better analysis


Rohit Chauhan said...

Hi akash
i generally dont prefer out of money put options on indices. as far i know taleb bets on them assuming that 99% will expire worthless, but the 1% will make him huge money and be worth it.
i am not emotionally built to invest that way and cannot lose money for a long time and hit the jackpot once.
i would rather invest in options on individual stocks with clear short term catalysts


mypursuitofperfection said...

Hi Rohit,

I loved this post of yours.

Now after reading this, if someone doesn't get it..there's nothing more we can do..:-)