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.
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
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
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