as part of our
In this series, we've asked Covestor managers: "What is the
single most important lesson you've learned while striving to
become a successful investor?"
About 15 years ago, I got my first job on the "buy side" of Wall
Street. I was recruited to work at a money management firm as an
analyst, covering the technology sector. The late 1990s was
an exciting time, with the dot.com revolution happening and hardly
a day went by without some big IPO blasting into the
Though I wasn't assigned specifically to any team, I spent a lot
of time working with a small-cap growth portfolio manager, Al. Al
wasn't much older than I was, but he was a lot more experienced.
One thing I noticed about Al was that he didn't seem very happy
when his fund had a good day of performance. He might have had a
company report earnings, or announce a big strategic partnership,
and that fund holding might have gone up 20% in a day. So on that
day his fund might have gained, say, 10 basis points compared to
the performance of his benchmark, the Russell 2000 Growth
To put this in perspective, a ten basis point gain in a single
day is pretty good. In those days, if you finished a year 250 basis
points ahead of your benchmark, you'd max out your performance
I'd lean into his office and said, "nice move in Polyrazzmatazz
today, huh?" But Al would shrug and perhaps ask what I thought of
another company whose management we had met earlier in the day. I
don't recall if I ever asked Al point-blank why he wasn't more
fired up on good days.
Fast forward a couple of years, after I was hired away to be a
portfolio manager myself, also on a small-cap growth fund. And it
was there, working alongside a really smart lead manager, that I
quickly understood what he called "portfolio mathematics" and why
my old buddy Al wasn't out taking victory laps on a good day.
Now that I was directly responsible for a fund, I took a lot
more notice of the day-to-day fund performance versus our
benchmark. It was like riding a bucking bronco. Up 35 basis points
versus the benchmark one day. Down 35 the next. And generally there
was no news to account for any of this. We might be far from
earnings season on a slow day in August, yet we were bouncing
around like a pogo stick.
"Do the math," my lead manager told me one day. "We own about
100 positions, in roughly equal weights. Even if each of them gains
only 1 percentage point compared to the benchmark, that's a 100
basis point gain right there. "Or," he said ominously, "you could
have just as easily lost 100. For no good reason. " And we
routinely had days where the whole portfolio was up or down three,
four or five percent, with our benchmark moving with the same
amount of volatility.
At some point, he also explained the performance risk inherent
in the otherwise benign "bid" and "ask" prices of stocks. Each of
our positions might have a bid-ask spread of about 0.5% - say, for
example, $9.98 bid by $10.03 ask. Suppose they all closed last
night on the ask. And today, even though the market might have been
roughly flat, with neither the bid nor ask changing, they all
happened to close on the bid. The stock market went nowhere, but
you managed to "lose" 50 basis points. It made me glad our boss,
the head of equities, was herself an experienced portfolio manager
and understood "portfolio math."
And thus the single most important lesson I've learned about
investing is that
on any given day, the noise of the market is far more
powerful than any signal.
And it's very easy to react to that noise as though it has meaning.
And, therefore, it's very easy to take action (buy, sell) when
really, no action is necessary.
Let's put some more numbers together to explain this phenomenon.
In 2009, the
Nasdaq Composite Index (the "Comp") rose
, as the economy began to recover from the global financial crisis
that peaked in 2008. Specifically, the Comp rose 43.9% that
year, or an average gain of 0.14% for each of the 252 trading days
in 2009. But that was just the average daily gain. Can you guess
how many days the Comp rose only that much or less?
Answer: 13. On the other 239 trading days, the Comp rose more
than 0.14%, or fell. Even if you include the days where the Comp
fell by less than -0.14%, the total is only 28 days. The other 224
days were Mr. Market's Wild Ride. On Inauguration Day, January 20,
the Comp fell 5.8%. On March 10, the Comp jumped just over 7%. And
this was one of the best years ever for the Comp; most years, the
average daily move is much less than +0.14%. But the volatility is
In other words, the stock market is an over-reaction machine.
Over any stretch of time it's 11 steps forward and 10 steps back.
Or five steps forward and eight steps back. Which is why
absent specific news about a company (earnings, big contract,
lawsuit), most of a stock's daily price movement is just pure
noise. And reacting like it means something is deeply unwise.
The great poker champion Chris Ferguson once said that the results
of a hand of poker are 99% luck and 1% skill, but the results of a
poker career are 99% skill and 1% luck. And the same is true of
investing: the longer the time frame, the more the result of an
investment decision is due to skill (or lack thereof) and the less
it is due to market noise. Do your research, make your investment
and put on some noise-cancelling headphones.
My belief in this signal-versus-noise relationship was only
enhanced when I read the book
Fooled by Randomness
by Nassim Taleb, published in 2004. I strongly recommend this book
for any investor. It was hugely influential on me, and many of the
concepts discussed in it validate the strategy we use in managing
the Crabtree Technology model.
To honor Mr. Taleb, I'm going to give him the last word, as he
writes about listening to a fund-of-funds portfolio manager discuss
other managers' performance:
"[I] suspected that he was fooled by randomness…the extent had
to be far greater than one could imagine. A back of the envelope
calculation showed that at least 97% of what he was discussing was
just noise. The fact that he was comparing performances made the
matter far worse."
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