One of the many nuggets of wisdom from Fooled by Randomness by Nassim Taleb – I wish I am capable of coming up with such stuff.
Assume that you have an investor who is capable of earning a return of 15% with a 10% volatility. It means that out of 100 sample paths, we expect close to 68 of them to fall within a band of plus and minus 10% around the 15% excess return.
A 15% return with a 10% volatility translate into a 93% probability of success in any given year. But seen on a narrow time scale, this translates into a mere 50.02% probability of success over any given second.
A minute by minute examination of his performance means that each day (assuming 8 hours a day) he will have 241 pleasurable minutes against 239 pleasurable ones. These amount to 60,688 and 60,271 respectively, per year. Studies have shown that investors feel more pain for given negative performance than pleasure in a positive performance of the same magnitude. Therefore, it is likely that the investor incurs a large deficit when examining his performance at a high frequency.
Consider the situation where the investor examines his portfolio only upon receiving the monthly account from the brokerage house. As 67% of his months will be positive, he incurs only 4 pangs of pain per annum and 8 uplifting experiences. This is the same investor following the same strategy. Now consider the investor looking at his performance only every year. Over the next 20 years, that he is expected to live, he will experience 19 pleasant surprises for every unpleasant one!
In today’s era of connectivity, it is not uncommon for investors to have live updates on share prices. This only exacerbates the mental assault on investors. Mental discipline is critical in discerning noise from real information – easier said than done, of course. Keep in mind that Taleb is not advocating that investors lose touch with the company fundamentals. The key message would be that the randomness of share prices makes it an insalubrious affair to be monitoring them. However, I guess this can be abit tricky to practise as investors do use share price as a first indication of a change in fundamentals.