Changes in the prices of securities can take various forms: choppy volatility, extended trends, sudden reversals, melt-ups or crashes. And they can represent any number of things: disaster, success, warning, opportunity, distraction, or irrelevance.
A change in price is made meaningful to you by its relationship to your investment process and your portfolio positioning. Intraday price movements might be completely irrelevant to a long term investor, but intra-second movements might convey valuable information to a high-frequency trader.
Noise, as I define it, is the set of disruptions and disturbances that undermines your ability to function at an optimal level as an investment professional. Some price action fits this definition but some does not. The change in price, in and of itself, does not indicate whether it’s noise. What makes price action a source of noise is whether it causes you to do something that is inconsistent with your investment process. If changes in price force you to diverge from your process, then those changes are clearly not something to be waved away as an irrelevance, those changes are a source of noise that is likely to lead to the destruction of alpha.
Sudden big price moves are an obvious source of acute noise. They tend to catch you by surprise, which can trigger in you a neurobiological and psychological chain reaction that results in errors of judgement and in the destruction of alpha.
But it doesn’t have to be all sturm und drang for price action to be a source of noise. The small and unexceptional moves that reflect the market’s normal behaviour on most ordinary days are less obviously threatening to your ability to generate alpha. Even though this price action doesn’t make headlines, it still can be a problem. It is the ongoing normalcy of these small moves that makes them seem benign when in fact they are a source of chronic noise that detract from your ability to generate alpha.
Any price move, large or small, that distracts you from your process is noise. So if you find yourself watching small intraday moves on your screens, that price action is noise if it diverts your attention to doing something which is unlikely to result in alpha-generation.
There are two related ways in which unexceptional price action destroys alpha, the first of which is screen-watching. Fund managers know that this activity is thoroughly counter-productive and yet most fund managers do it, and those that acknowledge doing it tend to vastly underestimate the amount of time that they spend doing it. This activity captures your attention and diverts scarce resources away from properly alpha-generative work, like doing some deep analysis in a low-coverage area. It’s way less taxing to watch a screen than to think critically or creatively, but that is part of its narcotic appeal and it naturally carries a significant opportunity cost. It is also viciously circular: the more that you are sucked into watching unexceptional price action, the more price action you will be exposed to and the more compelling your screen-watching becomes. Little wonder that so many fund managers are addicted to this activity. You’re an addict when you know that something is bad for you but you can’t stop doing it.
The second way in which unexceptional price action destroys alpha is that when you allow yourself to be lured into screen-watching, the frequency of your price observations naturally rises; and the more frequent your observations, the more frequently you will tend to trade. If your trades are executed without a sound basis in your investment process or without an informational edge, then your overtrading is going to eat up alpha.
Screen watching is an apparently benign activity but one that needlessly squanders scarce cognitive resources, and it is a gateway to overtrading and higher portfolio costs. While this makes for a far less dramatic story than a massive sell-off in global markets, the indirect and direct costs associated with the chronic noise that arises from unexceptional price action are costs that are unnecessarily incurred by far too many fund managers and which compound over time and take a bite out of available alpha. The good news is that this is one of the more ready sources of additional return that you are likely to encounter, and it’s practically begging to be captured.
- How much of your day is spent screen-watching? Are you sure it’s really so little?
- What might be a better way to deploy your cognitive resources?
- What first steps will you take to wean yourself off this costly habit?