The headline of this column is purposeful. The idea is not to add to the noise but rather to help investors navigate through the firehose of information they face every day.
In the investing context, noise is information that will have little or no impact on long-term returns and isn’t important for making investment decisions. It may be interesting, entertaining and often have a sense of urgency, but it’s not going to affect the health of your portfolio.
I’m referring to economic statistics that bounce around from month to month, elections and political posturing in Washington and Ottawa, speculation about the next earnings report, comparisons to previous cycles, short-term market predictions and the U.S. Federal Reserve chairman’s body language. And then there’s the ‘the market was up/down today because of ______.’
You’ve probably noticed items like this fill your newsfeed. Information you won’t remember a week from now and that won’t be visible on a stock chart next month.
So, what should you pay attention to and what’s just noise? Joe Wiggins, director of research at St. James’s Place, a British wealth manager, offers valuable perspective. In a recent post on his Behavioural Investment blog, he has two key questions to help identify “harmful noise in financial markets.” Does it matter? And is it knowable?
Does it matter?
Will the information or views you’re reading have any impact on the long-term value of the companies in your portfolio?
Perhaps, but the most recent statistic or announcement carries an undue amount of influence, sometimes causing the media and stock market to overreact. New information can help analysts refine their forecasts, but is usually a single data point amongst a myriad of other factors and interactions.
There’s a good hockey analogy for this recency effect. After scoring two goals in the season opener, a left winger, who is a consistent 15-20 goal scorer, is suddenly expected to score 40 this season.
Economic statistics are a large part of the noise quotient, which makes economists rock stars in the investment world. These disciples of the dismal science are good at making short-term predictions on a variety of factors but rarely trained to link them to the stock market. They generally put too much weight on the direction of the economy, assuming a tight predictable connection for which there’s no evidence. The economy is more about this year. The market looks years ahead.
Is it knowable?
Is what someone is telling you possible to predict, and if so, is the person expert enough to do so? The investment industry is particularly prone to making confident pronouncements about outcomes that are impossible to predict. It’s particularly prevalent right now during the leadup to the U.S. election.
To many people’s surprise, long-term investment returns can be predicted more accurately than the periods just ahead. For a bond portfolio, the current yield is a reliable indicator of returns over the next 10 years. For instance, the current index yield of 3.7 per cent suggests investors can expect to earn 3 per cent to 4 per cent per annum over the next decade.
If you ask about next year, however, nobody has a clue. That’s because the other component of a bond’s return – capital appreciation or depreciation driven by changes in interest rates – is difficult to predict and at times can overwhelm the income component.
It’s similar for stocks. Of the three contributors to return, two are reasonably predictable for longer periods. Dividends are stable, and profit growth settles into a narrow range with time. The third input, however, is a wild card. Change in valuation can swamp the other two factors over shorter periods. That’s been the case in the last two years when expanding price-to-earnings multiples have been the main driver of higher stock prices.
Swings in valuation are hard to anticipate, making market forecasts suspect, no matter how reasoned they appear to be. Fortunately, like bonds, multiple expansions and contractions become a non-factor when spread over a longer time frame.
The next time you’re feeling overwhelmed by a flood of information from the media or your adviser, take a step back and ask the questions: Does it matter and is it knowable?
Tom Bradley is co-founder of Steadyhand Investment Management, a member of the Investment Hall of Fame and a champion of timeless investment principles.
