Nassim Taleb advocates minimal exposure to the media as a guiding principle (read the previous post in this series here) because humans inherently are unable to tell the difference between noise and information.
Realizing this inability can lead to more generalized conclusions. First, we examine the difference between noise and information through an example borrowed from the investment world:
Let us manufacture a happily retired dentist, living in a pleasant, sunny town. We know a priori that he is an excellent investor, and that he will be expected to earn a return of 15% in excess of Treasury bills, with a 10% error rate per annum (what we call volatility). It means that out of 100 sample paths, we expect close to 68 of them to fall within a band of plus and minus 10% around the 15% excess return, i.e. between 5 and 25% (to be technical; the bell-shaped normal distribution has 68% of all observations falling between -1 and 1 standard deviations). It also means that 95 sample paths would fall between -5% and 35%.
Clearly, we are dealing with a very optimistic situation. The dentist builds for himself a nice trading desk in his attic, aiming to spend every business day there watching the market, while sipping decaffeinated cappuccino.
The dentist is clearly a skilled investor. With a mean return of 15 percent and a volatility of 10 percent, the dentist can expect to be successful 93 percent of the time in a given year. That is, the dentist will achieve positive excess returns. When examined on extremely short time scales, however, the dentist will have only a marginal chance of achieving positive excess returns. On a given second, for example, the dentist has a 50.02 percent chance of success:
Over the very narrow time increment, the observation will reveal close to nothing. Yet the dentist’s heart will not tell him that. Being emotional, he feels a pang with every loss, as it shows in red on his screen. He feels some pleasure when the performance is positive, but not in equivalent amount as the pain experienced when the performance is negative.
At the end of every day the dentist will be emotionally drained. A minute-by-minute examination of his performance means that each day (assuming eight hours per day) he will have 241 pleasurable minutes against 239 unpleasurable ones. These amount to 60,688 and 60.271, respectively, per year. Now realize that if the unpleasurable minute is worse in reverse pleasure than the pleasurable minute is in terms, then the dentist incurs a large deficit when examining his performance at a high frequency.
Here Taleb draws upon one of the fundamental assumptions of economics and finance — humans are risk adverse in that they fear losses more than they like gains. On a short time scale, investors observe the variance of the portfolio, not the returns. This variance contains little information of value, and in fact, observing a portfolio at any time scale always contains a combination of returns and variance. Furthermore, human emotions are unable or unwilling to understand the difference between the returns and variance of a portfolio. Undue reliance on short term fluctuations in a portfolio can be very damaging to an investors mental health:
Finally, this explains why people who look too closely at randomness burn out, their emotions drained by the series of pangs they experience. Regardless of what people claim, a negative pang is not offset by a positive one (some psychologists estimate the negative effect for an average loss to be up to 2.5 the magnitude of a positive one); it will lead to an emotional deficit.Now that you know that the high-frequency dentist has more exposure to both stress and positive pangs, and that these do not cancel out, consider that people in lab coats have examined some scary properties of this type of negative pangs on the neural system (the usual expected effect: high blood pressure; the less expected: chronic stress leads to memory loss, lessening of brain plasticity, and brain damage). To my knowledge there are no studies investigating the exact properties of trader’s burnout, but a daily exposure to such high degrees of randomness without much control will have physiological effects on humans (nobody studied the effect of such exposure on the risk of cancer). What economists did not understand for a long time about positive and negative kicks is that both their biology and their intensity are different. Consider that they are mediated in different parts of the brain — and that the degree of rationality in decisions made subsequent to a gain is extremely different from the one after a loss.
Restricting oneself to noise (either to the media or the short-term fluctuations in one’s portfolio) can lead to more rational investing decisions. “Silence is far better,” writes Taleb.