Portfolio diversification is supposedly as close to a free lunch as you’re likely to get in the investment industry. The idea is very compelling: construct a portfolio of uncorrelated assets and you’ll be relatively immune to market shocks. Great.

But as soon as markets are hit by a storm of sufficient strength, the non-correlation that existed during a period of calm reveals itself to be illusory. It’s there when you don’t need it at all, and it disappears when you need it most. Some lunch. Not so free. You know this already. As the old cynics amongst us say, the only thing that goes up in a crisis is correlation.

The reason for this is that markets are not merely manifestations of pure numerical rationality. Markets are also messily psychological. The human participants in markets are prone to all sorts of non-rational behaviour, and this is always exacerbated by the existence of noise. In my book on the subject, unsurprisingly called Noise, I define noise as the set of acute disruptions and chronic disturbances that undermine your ability to function at an optimal level. I identify 10 sources of noise that account for virtually all of the difficulties experienced by professional investors. The most obvious of these is the way that different sorts of price-action affect you psychologically.

Any one of the ten sources of noise might not seem to be that big a deal in and of itself. But all of them are related to one another in a variety of ways that are not always altogether obvious. And this means that noise emanating from one source can trigger contagion amongst a number of other sources, and these can combine into a destructive psychological storm.

Put another way, these combinatorial relationships give rise to nonlinearities, which means that a seemingly innocuous blip in one source of noise can quickly spark a systemic cascade and take you deep into your danger zone. You don’t want that. So, what can you do about it?

You can think of noise in two ways:

  • Acute Noise. A sudden, intense disruption.
  • Chronic Noise. On-going, low-level disturbance.

You are more likely to experience a destructive psychological storm if you have an unmanaged base-load of chronic noise. Chronic noise has a corrosive effect on your ability to deal with the complex problems of day-to-day fund management. It also erodes the buffer of cognitive, emotional and physical resources that you will need to draw upon to withstand the unexpected but periodic assault of acute noise. 

When there is a spike in acute noise that comes on top of already high levels of chronic noise, your capacity to deal with the situation in a constructive manner is massively compromised. You can find yourself doing things that you shouldn’t, or not doing things that you should. Either way, it sets you up for regret. 

Cool thing is, it needn’t be thus. If you choose, you can take steps to prevent yourself from being overwhelmed by a psychological storm. The best place to start is by managing chronic noise, and perhaps the best place to do that is by attending to a difficult relationship with a member of your team. And the best way to do that is by improving the quality of conversation you’re holding with that person. Every conversation matters, and high quality conversations reduce chronic noise.

This probably looks like work that you’d rather not do, which is fair. But if you do take on this difficult task, you might even wind up improving the culture of your team. Why? Because you change a culture one relationship at a time, and you change a relationship one conversation at a time. 

Reflection

  • What are the major sources of noise in your professional life?
  • How are these related to one another? What might that mean?
  • How will you inoculate yourself against a sudden increase in noise?