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OPINION

Block out the noise

Block out the noise
July 21, 2016
Block out the noise

One reason for this is that a lot of stock market developments are noise rather than signal: they tell us nothing about future returns or risk. Acting on such noise runs the risk of incurring unnecessary costs by trading too much.

The converse of this is also true. Many significant price moves happen without warning. Sterling's fall on the referendum result, the closure of some commercial property funds, and the rotation out of domestic cyclicals and into defensives and overseas earners all occurred suddenly and unpredictably. Looking for a portent of these moves would have been a waste of time.

A second reason not to pay attention lies in what Richard Thaler and Shlomo Benartzi have called myopic loss aversion - the fact that even good assets look unattractive if judged every day.

To see this, imagine an asset with an average return of 10 per cent per year with a standard deviation of 20 percentage points. This is a good investment; twice as much as UK equities have been in the long run. However, it has an almost 50:50 chance of falling in any single day. Over 12 months, though, there's only a 31 per cent chance of a loss and over five years only a 9 per cent chance.

This simple example warns us that it is only in the longer term that good assets look good. Looking at daily returns can therefore divert us away from good investments.

>Andrew Abel at the University of Pennsylvania has shown that the best thing a rational investor can do for long periods is to ignore the market

On top of all this, there are psychological costs to paying close attention to the market. When prices fall, we naturally worry that they might not rebound, simply because we can never be wholly confident that the fall is due to overreaction or to an increased risk premium. And when prices rise we risk wrongly increasing our spending or retirement plans. Worse still, we might mistake a bull market for our own skill, and so become overconfident, with the result that we take on too many risks.

For these reasons, Andrew Abel at the University of Pennsylvania has shown that the best thing a rational investor can do for long periods is to ignore the market.

That said, doing so can have two costs. One is that we might miss out occasionally on genuine signals. One class of these is when prices cross their 10-month moving average. However, I'm not so sure that such signals remain robust when we experience genuine environment-changing shocks such as Brexit.

A second cost is that inattention generates market inefficiencies. Some US economists have shown that shares that enjoy steady drips of good news see stronger momentum effects than those that get a single piece of news. This is because such drips don't attract as much attention as they should. This means that prices underreact, with the result that they rise later as investors eventually cotton on.

However, I'm not sure if this is a reason for investors to pay closer attention. It's impossible to monitor hundreds of stocks closely. This market inefficiency arises from inherent limits on our powers of cognition.

On balance, I suspect there's much to be said for paying less attention to markets - and, perhaps, to 'news' generally.