Noise affects what you see, what you think, and what you do. When you are subject to relatively benign levels of noise, your state of functioning will be largely unaffected. But as noise begins to increase, it impacts on your physical self, your emotional self, and your cognitive self. When noise passes through your critical threshold, your cognitive functioning will deteriorate sharply.
Noise affects how you perceive the world, how you process what you have perceived, and what you decide to do with what you have processed. If your perceptions are distorted and your processing is distorted, it’s highly probable that you will make errors of judgement.
When your noise levels are elevated, you will see less clearly because you will experience two types of perceptual distortion.
- Spatial Distortion. This occurs when conditions of acute noise cause you to experience perceptual narrowing, and this tunnel vision results in you missing peripheral data, information that is not in the centre of your perceptual field.
- Temporal Distortion. This occurs when conditions of acute noise cause you to experience perceptual foreshortening of time, and this myopia results in you not seeing possibilities beyond the immediate first-order consequences of the situation that you face.
Noise makes you see a mere subset of the available data; you see only the obvious and the immediate. Data that is obvious and immediate is always most readily incorporated into the prices of securities. This data seldom, if ever, represents an opportunity to generate alpha. Noise crowds out potentially valuable information, and therefore noise undermines the quality of the inputs into your analysis.
Noise also negatively affects your ability to properly process the data that you have gathered. Human brains, as awesome as they are, have limited processing power. Even at the best of times all humans are cognitive misers. You attempt to solve difficult problems while spending the least possible amount of mental effort. You are prone to cognitive biases because you will try to take mental shortcuts to save energy.
When you experience elevated levels of noise, a significant quantity of your already limited processing power is drained away. This is why even experienced fund managers unconsciously substitute complex questions with questions that are related to the difficult question but which are easier to answer. You answer the easy question while believing that you have answered the difficult question, which leads you to make a decision error. Noise causes discontinuities in your cognitive processing; it interrupts the smooth running of clean sequential logic.
When you make investment decisions under conditions of elevated noise, you are virtually guaranteed to destroy alpha. When you engage with your colleagues and clients under conditions of elevated noise, you are virtually guaranteed to damage the relationship. That’s not good.
But it needn’t be so. One of the simplest ways to ensure that you don’t put a hole in your track record is to become more aware of your noise levels. Then you can start to manage the noise.
- What are your sources of noise, whether acute or chronic?
- What is your critical noise threshold? And where are your noise levels now?
- What one thing could you do to reduce the impact of noise? When will you start?