Noise - Chapter 4
Nature Of Noise: Noise Is An Opportunity
Briefly: Noise Is An Opportunity
Paradox. Noise is an opportunity because it’s a problem.
Problem. Noise creates pricing inefficiencies, but also makes it difficult to capture the mispricing.
Opportunity. The better you are at managing noise, the greater your ability to exploit your competitors’ noise-induced errors.
Your job as an active fund manager is to take advantage of informational and behavioural asymmetries. Without pricing inefficiencies, there would be no prospect of you capturing alpha. These asymmetries exist because of noise; without the problem of noise, everything would be priced efficiently. But noise also makes it very difficult to take advantage of the inefficiencies.
This seems to trap you in a dispiriting circularity. Fortunately, there is a fourth category of noise that points the way out.
Generalised Noise / Localised Noise
These two types of noise are different in this way:
Generalised. Generalised noise is experienced by all people.
Localised. Localised noise is experienced by you.
Noise is a problem when you experience it, when it’s localised, because it undermines your capacity to function at an optimal level. But everyone, every fund manager everywhere, is subjected to noise to some degree; therefore it’s a generalised phenomenon.
When you deal with noise better than your competitors you have an advantage. The better you deal with noise, the less prone you are to the cognitive biases that undermine your investment performance, and the less susceptible you are to the non-constructive behaviours that undermine your professional relationships. When localised noise is lower than generalised noise, you have an edge because you can take advantage of others’ noise-induced errors of judgement.
Dealing with noise is a relative game; you don’t have to be 100% noise-free yourself in order for noise to represent an opportunity, you just have to experience relatively lower noise levels than your competitors. To transform noise from a problem into an opportunity, you have to deal with noise; and to do that, you need to understand noise. Section 2 of this book will deepen your understanding of noise, and Section 3 will improve your management of noise.
Noise is an opportunity because it is a problem. Noise is a problem for the many, but an opportunity for the few.
References
Black, F. (1985) ‘Noise.’ Journal of Finance. Volume 41, Issue 3.