Friday, December 16, 2005

Responding to Noise

"There is lots of noise that comes with information and one needs to train himself to separate noise from information" -- Naseem Taleb (in substance)

Over the past few weeks, I have realised that two areas where discerning information from noise can be of great help are decision making & interpretaion of financial information.

I will use a famous experiment done by Tversky & Kahneman & quote Charlie Munger, Buffett, & Ralph Wanger to drive home the point.

Decision Making:
Success or failure is a consequence of decisions that we make over our lifetime. We can control our decision making process but not how they will fare out. This reminds me of wonderful quote by Ayn Rand,

"One can evade reality but he cannot evade the consequences of evading reality."

To understand how to make decisions I think it is important to realise how decisions are not to be made & work backwards from there.

Psychological tendencies (or) Noises:
We all get, to varying degrees, influenced by psychological tendencies while making decisions. Some of the most common are Availability Bias, Doubt avoidance tendency, Inconsistency avoidance tendency & Psychological denial. (List of other tendencies)

Tversky & Kahneman's Experiment:
Question: 'Are there more words in english language starting with letter 'K' (or) with 'K' as third letter?'

Tversky: "The responses to the question illustrate the general principle that people use to reason under the conditions of uncertainty. They try to think of examples of the word starting with 'k' & with 'K' in the third place. Just because it is much easier to recall words starting with 'K' they assume that there must be more letters starting with K whereas in reality there are twice as many words with K in the third place. We refer to this as Availability Heuristics."

Charlie Munger on Human misjudgment:
"The brain of man is programmed with a tendency to quickly remove doubt by reaching some decisions" (Doubt Avoidance Tendency)

"The brain of man conserves programming space by being reluctant to change, which is a form of inconsistency avoidance." (Inconsistency Avoidance Tendency)

"It is easy to see that a quickly reached conclusion, triggered by Doubt avoidance tendency, when combined with a tendency to resist any change in that conclusion, will naturally cause a lot of errors in cognition for modern man."

I think that we should train ourselves on how to deal with these biases while making decisions and one of the ways of doing that is to try what Charlie Munger has done all through his life,

"I have long looked for insight by inversion in the intense manner counseled by the great Jacobi: 'Invert, always invert.' I sought good judgment mostly by collecting instances of bad judgment, then pondering ways to avoid such outcomes."

Interpretation of Financial Information:
The movement of stocks or markets is a function of how a given news or event is interpreted by the group of investors & traders. If we interpret those news or events the way most of the investors do then we will end up doing the same things as most of the investor & with the same results too. This is where I think we need to train ourselves to think differently than the herd which we are trying to outrun. This is well explained by Ralph Wanger as,

"If you want to stand out of the pack, you have to think out of the pack"--Ralph Wanger.

Having said that I would like to add that being contrarian for the sake of being one can be cited as similar to markets overreaction to good news.

Buy & Sell Decision?
We all aspire to be successful. But confusing that aspiration with the means to attain that objective can be dangerous (ie) while deciding when to buy & when to sell, we should not let our subjective aspirations clash with what the current situation--based on the value of the underlying stock-- warrants us to do.

Taking a loss should not make us feel like a stupid, if our process is right & taking a profit as genius, if our process if wrong. One can hope to achieve what he aspires in the long run. But, in the short run, we have to learn to accept what we deserve & keep on improving.

During the last decade or so, with the development of internet, ease with which the information gets transmitted from one place to other has increased substantially. Thus it becomes even more important that we respond to information that we think are information & not noises.

"You don’t need 99 percent of the information out there for investments”-Warren Buffett.


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