It is a truth, now universally accepted, that investment opinions and decisions are made both intuitively fast and analytically slow. Daniel Kahneman’s book Thinking Fast and Slow
revolutionised how we think about how we think.
For those looking to wade through Kahneman’s small-print, 500-page life’s work, I recommend starting with Michael Lewis’ The Undoing Project
, which explains the relationship between Kahneman and his friend and collaborator Amos Tversky, who sadly died before he could receive the Nobel Prize that he would have won with Kahneman in 2002.
Kahneman illustrates our natural human biases – that we dislike losing more than we like winning (the prospect theory), that our decisions are based on the information in front of our noses (availability), and that we match new situations to our experience of old ones (representativeness). The good news is that, despite our biases, most of our decisions are about right.
His latest book, published last month at the age of 87 together with eminent behavioural economist Cass Sunstein, and former McKinsey partner Olivier Sibony, is called Noise
. It is subtitled A Flaw in Human Judgment
and illustrates the striking variability of judgment by different seasoned professionals with the same information.
The US judge Marvin Frankel was so disturbed by defendants getting wildly different sentences for the same offence that, in 1974, he asked 50 judges to pass sentence on a hypothetical extortion case. The jail sentences ranged from three years to 20. Similarly, I have worked in investment teams where individual experienced fund managers have delivered variable results in the same market conditions.
Daniel Kahneman at a conference in Hong Kong in 2004. Photo: Handout
Variability of opinion is due to the different emphasis we place on parts of the same evidence. That difference is driven by our emotion, values and upbringing, which impart biases to our thinking. The truth lies within the information flow, but distracting noise hides it in plain sight.
The lack of warning about the Japanese attack on Pearl Harbour was due to the belief that
domestic sabotage was more likely
than a direct attack by an external foe. That noise meant the US was taken by surprise
by the approach of the aircraft carrier fleet, so much so that some Americans came to believe a conspiracy theory that the US government was complicit in the attack. Noise is the enemy of the truth.
Although Kahneman, Sibony and Sunstein define noise as the variability of decision-making, it is perhaps more simply thought of as distracting information, which may be true but irrelevant, or misleading, or fake – or a combination.
In narrative finance, we study the information flow from stories in the market that combine the underlying truth and the noise in such a way that it makes the truth hard to spot. Asset prices are made within a non-linear, complex, adaptive system, which operates as a steady state.
When the underlying truth finally becomes obvious, the steady state fails, the system reaches a critical point, and we get a market crash. The global financial crisis was precipitated when the noise clouds parted to expose the mountains of subprime debt.
Pedestrians stand in front of Victorian homes in San Francisco in 2015. The 2008 financial crisis was triggered by the collapse of a housing bubble, resulting in the devaluation of financial products linked to subprime mortgages. Photo: Bloomberg
“Noise is what makes our observations imperfect,” said Fisher Black in his 1986 paper “Noise”. Investors try to trade on the truth; speculators (and retail investors) trade the noise. Punters think they are trading on information but can’t or won’t confirm the market’s underlying true value.
Noise affects the narrative we hear, that we understand and that we pass on to others. American statistician Nate Silver, in his 2012 book, The Signal and the Noise, wrote that “noise is what distracts us from the truth”. Truth and noise coexist like a Formula One racetrack alongside a commuter road; it’s usually fine but occasionally there is a mighty crash. Such a noisy but attractive analogy, perhaps repeated by a celebrity or officialdom, illustrates how credence can be attached to an otherwise worthless story.
While the virus causing Covid-19, if left unchecked, causes widespread illness and death, its reproduction rate can be controlled with measures tailored to the population. However, in such a situation, noisy narratives can feed fears – even though the Pfizer vaccine is the safest and most effective in decades.
The poor ability of humans to judge the probability of catching and dying from Covid-19 led some parents to lock their children (and their parents) away for a year, perhaps with even more serious consequences. Public policies have shuttered economies following knee-jerk decisions based more on noise than the underlying science.
The Hong Kong government’s overcaution in forcing up to 21 days of jail-like quarantine made people reluctant to report symptoms, while the length of time spent in quarantine may have increased the possibility of contacting Covid-19 within confinement itself.
Most people accept sensible health measures like banning smoking indoors or the use of seat belts. The need for vaccination is similar. The government will only increase vaccination levels by flipping their policy to allow the vaccinated to lead a normal life, while the unvaccinated remain restricted. Otherwise, the misleading (or deliberate) noise that the vaccine is dangerous will persist.
Richard Harris is chief executive of Port Shelter Investment and is a veteran investment manager, banker, writer and broadcaster and financial expert witness