I’m going to reference two awesome books in this post. They are must-have’s if you want to know money. They are books by finance blogger Jim Collins (http://www.jlcollinsnh.com) and a trader turned probability expert and essayist, Nassim Taleb.
Why would I talk about both of these books in the same post.
Reading both gives you almost everything you need to understand money. Damn close anyway.
Beer and Foam
Jim Collins book The Simple Path to Wealth has a section I love where he compares the stock market to a glass of beer. These glasses contain different amounts of beer and foam.
If you use a little skill to pour the beer, you can have a glass full of mostly beer with very little foam on top.
Pour the beer too quickly, you’ll have mostly foam and very little beer.
What if somebody else pours your beer into a mug that you can’t see through and then hands it to you. You have no way of knowing how much is beer and how much is foam.
The same problem exists with the stock market.
The Beer is the actual operating business of which you can own part of.
The Foam is the traded pieces of paper that rise and fall in price from moment to moment. It’s the unpredictable short-term fluctuations that CNBC and the Wall Street Journal love to speculate on.
When you see hourly, daily, even weekly fluctuations in prices, it’s hard to know whether those changes are coming from the beer or the foam. Whether those changes come the actual value of the company, or just irrelevant noise affecting prices in a way that has nothing to do with the company’s actual value.
Don’t be fooled by noise
In Nassim Taleb’s book, Fooled by Randomness, he addresses the same phenomenon in a more scientific manner. He calls it noise.
Mr. Taleb uses the example of a successful retired dentist who is also a very good trader. He explains that the dentist is such a great trader, that he is expected to earn a return on average of 15% with a 10% error rate per year.
That’s a fancy way of saying there will be some volatility, and about 68% of the time, he’ll earn between 5% and 25% a year. Volatility will cause losses on occasion.
These earnings with this volatility translate to a 93% probability of success (or positive growth) in any given year.
That sounds awesome!
That means if he looks at his stock prices once a year for 10 years, he will only have one down year, and have nine years with positive growth. This is amazing! Life is good.
What is important to realize, however, is that over short periods of time, an observation of the same stocks will reveal changes that are mostly noise. Useless movements of the stock that have no reason. They are almost entirely unrelated to the actual health and worth of the company.
If the dentist looks at his stock price often, say several times a day, he’ll see losses far more often then when he observes over longer intervals. These movements are misleading and confusing. You are better off not seeing them.
Watching these fluctuations, especially the downward trends, will be painful, and he will doubt his investment skills.
Here’s a table that shows the probability of observing a positive gain over different time periods. We already told you it was 93% for one year. Note how the probability decreases with observations becoming shorter and shorter.
Probability of observing growth at different intervals
1 year 93%
1 quarter 77%
1 month 67%
1 day 54%
1 hour 51.3%
1 minute 50.17%
1 second 50.02%
If the dentists looks at his stock prices every hour throughout the day, roughly half the time he’ll see red numbers on the screen. He’ll feel the psychological pain of losing money!!!
What if he looks at the screen every minute? second? It gets worse. He feels pain with every loss he sees.
At the end of every day, assuming he checks his stocks every minute, he has 241 pleasurable minutes (gains), and 239 bad minutes (losses).
We have to understand that a bad minute is far more painful than a pleasurable minute. This is human nature. Unpleasurable minutes are “more bad” than pleasurable ones.
The feeling of happiness you feel from a “good minute” is not enough to cancel out the pain felt in a bad one.
This means that, if he watches his stocks too closely, the dentist will end each day emotionally exhausted, and unsure of his ability to make money over the long run. This leads to making bad decisions, like selling prematurely.
What if he just checks his monthly statements instead of watching all day long on the computer in his basement?
In a year, he’ll have about eight good months and four bad. Psychologically much easier to handle.
Looking at the prices yearly, he’s almost always in the green! Maybe only one down month and the rest all up!!!!!
Mr. Taleb explains that this scaling property of randomness is wildly misunderstood, even by financial pros.
To mix the two stories I told together, you’re seeing much more foam (useless changes in prices) when you look at shorter intervals. When you observe less often, you’re seeing the beer (actual value of the company). The foam has already vanished.
This is what Mr. Taleb refers to as noise. Noise is foam. It’s the useless wild gyrations in the market that aren’t tied to anything solid.
Here are some important takeaway.
- Over short time frames, you only see the variability of the portfolio (noise or foam). These are poor indications of the real future returns. You’re seeing the variance and little else. This is useless information.
- Even if you are aware of this phenomenon, your emotions will not care and they’ll be upset with every loss they witness! Our emotions were not designed to handle stuff like this. The dentist was much happier when dealing with monthly statements instead of watching prices by the minute.
- If Mr. Taleb sees you watching stock prices on your phone, he’s going to laugh at you. I will too. It’s a waste of time, and provides no useful information.
The news is also full of this noise. Foam everywhere!! Attempts to guess the short-term movements of individual stocks is useless. Attempts to buy and sell based on news of mergers, crises, and rumors is a losing proposition.
Give me a break! It would be faster to get a gun and shoot yourself in the foot. The only guy getting rich day trading is the guy selling the seminars. The suckers are the ones buying them (sorry if that was you). This is the very definition of noise! If someone talks to you about it, turn around and run away screaming!!!!!!
Understand that the foam is out there. People love it. They get excited about it.
Wall Street makes billions publishing news and giving advice and making predictions as to the short-term moves of the market. This is foam. It’s noise. It’s a waste of your time.
When you see people freaking out about one bad day in the market, I want you to laugh, and realize how much energy you are saving. Then go home, crack open a beer, and pour it slowly into a glass (we want to avoid making foam).
Let’s not waste time or money on it any more.
As Jim Collins puts it, we are only interested in the beer.
Rich on Money
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Liked this post? Read my previous post about being Fooled by Randomness.
Read my first post ever, also featured on Rockstar, about how I paid off a $280k mortgage in six years and collected a large amount of rental properties mortgage free.