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Noise and bias in your investment portfolio

Bad decisions caused by both bias and noise are rampant in the market.

In Daniel Kahneman’s book, Noise: A Flaw in Human Judgement, Kahneman uses a particularly effective metaphor to illustrate the ways humans make bad decisions. Using the results from a gun range, his main thesis distinguishes between errors caused by bias versus errors caused by noise.

To illustrate bias, he observed the back of the paper target shot with holes, rather than the front of it. If most of the shots skewed left-centre, the shooter might actually have impeccable aim…if the bullseye happened to reside there. One could never be certain when only viewing only the back. Or, more likely, the shooter simply had bad aim, with a bias caused by a faulty gun sight or a tendency to pull the shots left.

To demonstrate noise, however, Kahneman found the back of the target with scattered holes displaying no apparent rhyme or reason. The implications were obvious. With bias, the error could be corrected by fixing the gunsight or one’s tendencies. With noise, though, remediation was much harder because the cause itself wasn’t evident. The shooter may have missed the target in each of the examples, but the reason they missed the target could be the result of bias or noise. And unfortunately for investors, bad decisions caused by both bias and noise are rampant in the market.

Noise vs bias

Most investors believe, at some level, that they have some capacity for prediction. This confidence can range from the vaguest “gut feeling” to the most precise quantitative models one can imagine. Yet the common theme is prediction.

Noise crumples all those techniques into paper balls and throws them in the trash. Because, in the end, each of those approaches addresses only a bias or a series of biases. None can account for the totality of noise, which goes unseen, by definition, nor can they quantify the amount of noise, which is a secondary issue unto itself. Worse yet, if a manager is successful at mitigating a certain bias for a time, it can create a false positive — the manager will think they conquered noise when, really, they only mitigated a specific or temporary investment bias. The history of the market is rife with managers who are successful in a specific situation but never or rarely repeat their former success.

This is the danger that Kahneman describes so eloquently: the hazard of mistaking bias for noise. If a gambler wins on a lucky roll, they don’t ascribe it to skill. Portfolio managers, though? They use that winning track record for years, even after their portfolio’s performance has sunk. Through one lucky mitigation of bias, a manager might subject his or her fund (and its investors) to noise for years to come.

Think of it this way: inexperienced investors assume they can take gambles and they will, at worst, break even if their portfolio is up and down a commensurate amount in consecutive years. This is simply not true. Worse, the amplitude of the loss and the harm caused by unfortunate timing can cause an increasing amount of loss. As it relates to bias and noise, a manager might or might not address bias in the short term, but they will likely never address noise in the long term.

In the chart below, we take a consistent, 6% return on $100 000 over a 20-year period and compare it to alternating annual returns of 24% and -12% (the sum of 12% theoretically equalling two full years of 6% performance). In essence, the blue line is a proxy for a manager that successfully mitigates bias in the short term before reverting to the mean, while the red line represents a manager in the same situation who times the market incorrectly.

Upon cursory view, it’s easy to see that the green line is the winner. What’s more interesting is the divergence between the three lines. If an investor was lucky and mitigated bias in the market correctly the first year, he or she actually remained ahead of the steady 6% trajectory for the first several years. Ultimately, their luck runs out around the 10-year mark, though, and the continuous stream of 6% leaves that investor’s portfolio in the dust. Yet, this is the best-case scenario for such alternating swings. If the investor guessed incorrectly about market bias in the first year, the results are devastating. With that initial $100k dropping to less than $90k, that investor then spends more than four years getting back to where they started. The result? That unlucky investor’s total hypothetical return would dwindle to approximately $193k rather than the approximate $302 in the 6% return scenario, or about 36% less.

How to mitigate noise

At Global and Local Asset Management, we don’t attempt to mitigate a specific market bias. Why bother? As market biases change and morph over time, a specific investment approach is bound to run its course. That’s a game of whack-a-mole we’ll leave to other managers.

We mitigate the risk of noise itself.

How? We use New Age Alpha’s developed system which focuses exclusively on the risk of human behaviour. They call it the Human Factor, a risk that comes from humans interpreting vague or ambiguous information in a systematically incorrect way. They applied an actuarial-based approach similar to that used by the insurance industry and then developed a proprietary metric to gauge the impact of human behaviour. It’s called the H-Factor Score and it represents the probability a company will fail to deliver the growth implied by its stock price.

We don’t try to pinpoint a specific bias that might pull a stock in a particular direction or try to predict that stock’s trajectory. We recognise the inherent futility in that. Rather, we simply gauge the noise surrounding a stock and, if there’s too much, we avoid it. That’s it.

Using the H-Factor Score as the foundation of our investment methodology, we can apply these probabilities to any portfolio or investment universe. We build portfolio solutions that aim to provide a dramatically differentiated and uncorrelated source of outperformance by simply avoiding the losers – mispriced stocks caused by human behaviour.

In the chart above, the hypothetical investor thought they could navigate the noise in the market on their own. They were wrong. And worse, if they were wrong from the start, their plight only grew all the more dire. Don’t be that investor. Use our H-Factor System to measure the risk of human behaviour and aim to avoid the losers in your portfolio.

About Us

At Global and Local Asset Management we firmly believe in stripping out all vague and ambiguous information from the investment process. This is why we use New Age Alpha’s developed system called Avoid the Human Factor (H-Factor). The H-Factor measures the probability a company will fail to deliver the growth implied by the stock price. This risk is caused by investors interpreting vague and ambiguous information and impounding it into a stock’s price in a systematically incorrect way. The lower the Human Factor, the more likely vague and ambiguous information has NOT been priced into the stock. The H-Factor System is a free comprehensive portfolio tool that enables investors to apply our Human Factor metric to over 6 000 stocks, ETFs, global indexes, and their own portfolios.

New Age Alpha is a global leader in building actuarial-based asset management solutions that aim to protect investor portfolios against this idiosyncratic risk caused by human behaviour. Investors are unaware of this risk that leads to loss, cannot be diversified away, and don’t get rewarded for taking it. Unlike firm-specific risk, which can often be diversified away, this risk affects stock prices specifically and we believe is caused by human behaviour. Through New Age Alpha’s research, they have identified a differentiated source of alpha that is uncorrelated with traditional risk factors and managers, and as the foundation of their investment approach, they have built a range of actuarial-based asset management solutions that aim to mitigate the risk of human behaviour.

If you would like to know more about how the Human-Factor score tool works and how we “Avoid the Losers”, then please contact us at Global & Local Asset Management.

By Matthew Waterman, Investment Writer, New Age Alpha

Disclosures

Global & Local Investment Advisors (Pty) Ltd is a registered financial services provider in terms of the Financial Advisors and Intermediary Services Act (FAIS). Global & Local Investment Advisors (Pty) Ltd holds FSP license number 43286.

Global & Local Asset Management (Pty) Ltd. Reg. Number: 2018/580284/07

Global & Local Asset Management is an authorised juristic representative of Global & Local Investment Advisors (PTY) Ltd FSCA License Number: 43286

Any investment performance figures quoted herein are for illustrative purposes only and should not be construed as investment advice.

Investment advice can be provided by Global & local Investment Advisors (Pty) Ltd but only after an analysis has been conducted of the investor’s current financial circumstances and investment portfolio, only then will a recommendation be provided based on that investor’s own circumstances by Global & Local Investment Advisors (Pty) Ltd.

New Age Alpha refers to the New Age Alpha separate but affiliated entities, generally, rather than to one particular entity. These entities are New Age Alpha LLC, New Age Alpha Advisors, LLC (“New Age Alpha Advisors”) and New Age Tau, LLC.

Investment advice is offered through New Age Alpha Advisors, LLC a wholly-owned subsidiary of New Age Alpha LLC.

New Age Alpha Advisors is an investment advisor registered with the U.S. Securities and Exchange Commission. New Age Alpha Advisors, located in the State of New York, only transacts business in those states in which it is properly registered or qualifies for an applicable exemption or exclusion from such state’s registration requirements.

Past performance is not indicative of future results. Current and future results may be lower or higher than those shown. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended and/or purchased by New Age Alpha), or an Index, product, or strategy made reference to directly or indirectly in this firm overview, will be profitable or equal to corresponding indicated performance levels. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. Historical performance results for investment indexes and/or categories generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment management fee, the incurrence of which would have the effect of decreasing historical performance results. Returns for one year or less are not annualised but calculated as cumulative returns.

No client or prospective client should assume that any information presented in this firm overview serves as the receipt of, or a substitute for, personalized individual advice from New Age Alpha or any other investment professional. Any charts, graphs or tables used in this firm overview are for illustrative purposes only and should not be construed as providing investment advice. Information contained herein does not reflect the actual performance of New Age Alpha’s products or portfolios. All research and data is simulated and should not be considered indicative of the skill of New Age Alpha. The research data presented has been calculated by applying each Index strategy backwards in time and is not a contemporaneous record of actual assets managed by New Age Alpha.

All New Age Alpha trademarks are owned by New Age Alpha LLC. S&P® is a registered trademark of Standard & Poor’s Financial Services LLC (SPFS). All other company or product names mentioned herein, including S&P®, are the property of their respective owners and should not be deemed to be an endorsement of any New Age Alpha product or strategy. This firm overview is limited to providing general information about New Age Alpha and its investment advisory services. It is for informational purposes only and should not be construed by a client or a prospective client as a solicitation to effect, or attempt to effect transactions in securities, or the rendering of personalized investment advice. New Age Alpha’s specific advice is given only within the context of its contractual agreements with each client. Investment advice may only be rendered after the delivery of Form ADV Part 2 (an investment advisor’s disclosure document) and the execution of an investment agreement by the client and New Age Alpha. New Age Alpha’s Form ADV Part 2 and descriptions and summary annual reports or its composites are available upon request.

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Mauro Forlin

Global & Local Asset Management

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