Tuesday, January 11, 2022

Systematic investing - Reducing the noise from discretion

 


What is one the important reasons for employing systematic investment strategies that is often not discussed - the ability to reduce noise from discretionary decisions. There is noise or variability in investment choices based on the person making the decision. Judges, given the same information, will not rule the same way. Traders, given the same situation, may not make the same choices. There is variability in answers that can lead to wider dispersion in performance. Most decision error focus is on biases, yet the dispersion in decisions will impact long-term returns.

A simple example that describes the problem was published in the Journal of Behavioral Decision Making "Clouds make nerds look good: field evidence of the impact of incidental factors on decision making". The researchers looked at admissions to a selective college for a sample of 682 students and found that when it was cloudy outside, there was a higher weighting on academic attributes over non-academic attributes on sunny days. Odd, but true.

This may not be the best example of noise, and I will accept that the title caught my eye. I am subject to biases. Vivid stories or information stick in my brain. Of course, this result could be a flagrant example of p-hacking and atheoretical analysis looking for causation when there is seeming correlation, but it is suggestive of a behavioral problem and decision noise.

There always is noise when we have individuals make decisions. They may not make the same decision twice given the same information. There are mood swings. There are attention problems. We are only human. The solution is setting rules in place to eliminate the noise. We can work on forecast biases, finding better rules, but we can take comfort in the value from noise reduction when we are systematic with our decision making.

No comments: