Ignore The Noise, Increase Your Returns

Market noise is the constant beat of secondary information that we're all subjected to daily. In its formal context, introduced by economist Fisher Black, noise refers to market movement that is caused by phenomena rather than by evidence of information. This post reviews the ins and outs of noise and how to ignore it to increase your odds of weathering noisy market conditions.

Noise creates market activity through trading that is conducted by market participants. Noise, such as trending news, can generate reactionary trades, market surges, or declines in stock prices. Noise is considered word of mouth movement rather than movement from engaged fundamental analysis.

According to Black, noise affects markets through distorted valuations or price inefficiencies. Noise momentum drives stock prices up or down creating price inefficiencies for a finite time. For example, the Internet bubble presented distorted overvaluations when market values grew incredibly rich from investor demand in the Internet and technology sector. The NASDAQ rapidly rose to 5132.52 points on March 10, 2000, before dropping to 2470.52 points on December 29, 2000. Noise traders attempt to accurately time the markets to reap enormous buying and selling opportunities.

Noise is also generated from future uncertainties and mismatched expectations. Uncertainties over prices, rates, and economic activity are common because market conditions and investor preferences are known to change, often rapidly and considerably.

Mismatched expectations represent another type of noise. Mismatched expectations derive from human bias, groupthink, and other forms of expectation that stray from rules of rationality. Overall, noise makes it very difficult to determine the way that markets work.

A sharp focus on long-term, rules-based, fundamental strategies may help to offset the intensity of noisy markets. A long-term view of market investments considers the overall health of the business, industry and markets, through periods of volatility and over/under valuations. Another approach to counterbalance short-term noise includes a rules-based, or passive, strategy. Rules-based investment strategies eliminate human bias to offer an alternative investment approach. Passive strategies often outperform the markets and are utilized in many ETFs and mutual funds.

Whether active or passive, value investment strategies show long-term outperformance over other investment strategies. In the graph depicted below, value strategies outperform growth strategies in emerging markets, generating a 10.5 percent average return versus a 7.6 percent average return for growth. Value strategies focus on fundamental measures of quality and performance that generally perform slowly yet gainfully for the duration.

Weathering market conditions takes discipline and a steady hand during turbulent times. Ultimately, if an investor’s goal is to withstand economic recessions, then ignoring the noise is likely to produce rewarding results over time.

Kahneman, D. Thinking Fast and Slow. New York: Farrar, Straus and Giroux, 2011.

Black, F. “Noise.” Journal of Finance Volume 41 (July 1986), 529-543.