Wednesday, July 6, 2011

Signal versus Noise

Understanding the difference between signal and noise is essential in understanding any system.

In Engineering, we talk about the Signal to Noise Ratio in a system as the ratio between actual signal and background noise.  Often, in a noisy system, it is hard to perceive what is actual signal and what is actually background noise.

And most of the systems we encounter in real-life are noisy systems.   Stock prices, for example, are very noisy.   You look at an overall stock price trend and it is full of peaks and valleys from day-to-day, but long-term, you see pricing trends that are pure signal.  And yet many people trade instead, based on noise, such as day-traders.

Worse yet are transient signals.  Prices in markets can spike and then sag, and these are transitory things in the long run.   The run-up in housing prices in the 2000's was pure noise, not signal, and yet people sit in wonderment as to why their housing prices don't "rebound" to the noisy levels of that era.  It was not true signal - that's why - just a transient voltage spike.

And unfortunately, sudden run-ups in prices look very attractive to people, causing them to invest - in houses, then tech stocks, then houses again, then gold - then back in tech stocks again (this time, for sure!).  And each time, when the system spikes, a dampening effect kicks in, pulling the system back to a stable mode - bringing prices back to long-term trends - signal, not noise.

What is this dampening effect?  This capacitor in our economic system?  Our free market.   When housing prices spike, people build more houses - incentivized by the increase in demand.  Demand then exceeds supply, and the price plummets.  Unfortunately, since supply was now overbuilt, prices drop further than they should, until excess inventory is absorbed by the flywheel of the market.  And this takes time.

And the same is true of Gold - with a cost per ounce of about $400 they are making a lot of it.  And when people stop panicking and stop buying out of Fear (and fear is never a sustainable market factor for long) then supply will exceed demand - just as the sun rises in the East.  And the price will depress.

And yet, it seems like the price of Gold has been going up a long time.  And that is one problem humans have with perceiving signals.   We think five years is an eternity and ten years an eon, when in fact these are blips in time.  What we see as long-term market trends are really just anomalies - instantaneous spikes.  We cannot perceive the signal from the noise.

And our economic system is getting noisier.  People are holding stocks for shorter and shorter periods of time.   And we are demanding profits not for the "long term" of years or decades, but in terms of quarters or even months.  If a company doesn't increase profits from quarter to quarter, we sell the stock and write their obituary.

Of course, this is an overall market trend, and the effect of millions of nervous and panicky investors all looking for the quick score - the next big IPO, the next big thing.  How can we protect ourselves from this?

It is hard to say, other than the usual time-honored techniques.  Diversify investments, pay down debt, find save harbors - all advice that is signal and not noise.

But noise is sexy, noise is fun, and noise is often unorthodox - and that is what people want to hear - you can make money without work or risk, you can get-rich-quick, eat all you want and lose weight.