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Yes, Taleb explains it very nicely. Actually, I only recently...

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MarsC

2,589 Posts.

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03/05/16

14:57

Post #: 17664185
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Originally posted by madamswer ↑

"As a believer in value investing principles, I like to preach that hourly, daily or even weekly stock price movements are of no consequence. But ultimately, I just can't help myself, and take a peak far too frequently. So looking in the mirror of brutal honesty, I guess it's a case of listen to what I say, not what I do..."

While you shouldn't beat yourself up too much about it, @MarsC, because we all do it to some extent, but we should be more vigilant against "tick-watching", because it is as habit forming as it is futile.

One of the best criticisms of the ills of excessive monitoring of share price movements I came across some years ago in one of the most instructive investing reads I have encountered, namely a textbook called "Fooled By Randomness - The Hidden Role of Chance in Life and in Markets", by Nassim Taleb.

Illustrating the difference between noise and information, Taleb writes:

"I thought hard and long how to explain with as little mathematics as possible the difference between noise and meaning, and how to show why the time scale is important in judging an historical event. The Monte Carlo simulator can provide us with such an intuition. We will start with an example borrowed from the investment world, as it can be explained rather easily, but the concept can be used in any application.

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 can expect close to 68 of them to fall in a band of plus and minus 10% around the 15% 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 supping decaffeinated cappuccino. He has an adventurous temperament, so he finds this activity more attractive than drilling the teeth of reluctant little old Park Avenue ladies. He subscribes to a Web-based service that supplies him with continuous live prices, now to be obtained for a fraction of what he pays for his coffee. He puts his inventory of securities in his spreadsheet and can thus instantaneously monitor the value of his portfolio. We are living in the era of connectivity.

A 15% return with a 10% volatility (or uncertainty) per annum translates into a 93% probability of success in any given year. But seen at a narrower time scale, this translates into a mere 50.02% probability of success over any given second, as show in the table below.

PROBABILITY OF SUCCESS AT DIFFERENT TIME SCALES:
Time Scale Probability
1 year 93%
1 quarter 77%
1 month 67%
1 day 54%
1 hour 51.3%
1 minute 50.17%
1 second 50.02%

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. Now realise that if the unpleasurable minute is worse in reverse pleasure than the pleasurable minute in pleasure terms, then the dentist incurs a large deficit when examining performance at high frequency.

Consider the situation where the dentist examines his portfolio only upon receiving his monthly account from the brokerage house. As 67% of his months will be positive, he incurs only four pangs of pain each year and eight uplifting experiences. This is the same dentist following the same investing strategy. Now consider the dentist looking at his performance only every year. Over the next 20 years that he is expected to live, he will experience 19 pleasant surprises for every unpleasant one!

Viewing it from another angle, if we take the ratio of noise to what we call non-noise, which we have the privilege here of examining quantitatively, then we have the following: over one year we observe 0.7 parts noise for every one part performance. Over one month, we observe roughly 2.3 parts noise for every one part performance. Over one hour, 30 parts noise for every one part performance, and over one second, 1,796 parts noise for every one part performance.

A few conclusions:

1. Over a short time increment, one merely observes the variability of a portfolio, not the returns. In other words, one sees the variance, little else. I always remind myself that what one observes is at best a combination of variance and returns, not just returns.

2. Our emotions are not designed to understand the point. The dentist did better when he dealt with monthly statements rather than more frequent ones. Perhaps it would be even better for him if he limited himself to yearly statements.

3. When I see an investor monitoring his portfolio with live prices on his cellular phone or his handheld, I smile and smile.

Finally, this explains why people who look too closely at randomness burn out, their emotions drained by the series of pangs they experience. Regardless what people claim, a negative pang is not offset by a positive one (some psychologists estimate the negative effect of 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 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 leading to memory loss, lessening of brain plasticity, and brain damage). To my knowledge there are no studies investing the exact properties of trader burnout, but a daily exposure to such high degrees of randomness without much control will have psychological effects on humans (nobody has 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 to the one after a loss.

Finally, note that implication that wealth does not count so much into one's well-being as the route one uses to get it.

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Yes, Taleb explains it very nicely. Actually, I only recently read his book for the first time (Fooled by Ramdomness). I read his book The Black Swan a number of years ago, which covers some of the same key concepts.

To be fair, it would take a fairly substantial price swing for me to get too emotionally swayed, in any given period.

On the subject of good reads, I've recently read (actually listened to the audio of) Howard Marks' book, The Most Important Thing. I seriously think it's one of the very best investment books I've ever read.

BOL Price at posting: 7.2¢ Sentiment: Buy Disclosure: Held
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