What is the Signal-to-Noise ratio in investing?

What is the signal-to-noise ratio

Trade deals, Geo-political developments, the emerging situation in the middle east, Ukraine-Russia, the rise of cryptocurrencies, the rise of AI and the impact on the economy and what it may mean for markets, global estimate for GDP growth, likely confrontation between the Fed Chair and the US President, Gold and Silver prices at all-time highs, Crude prices reviving, can commodity prices be far behind?

How can an equity investor interpret all that is described in the sentence above and that can be described as the current dialogue? – Noise

Signal-to-noise ratio (SNR) is a measure that compares the strength of a desired signal to the strength of background noise. It's a crucial concept in science and engineering, especially in fields like communication, audio processing, and medical imaging. A higher SNR indicates a stronger signal relative to the noise, which is generally desirable.[1]

In equity investing the use of SNR will be quite useful as well. Fundamentally what is necessary to understand the potential in an equity stock? Most logically it should be the expected return from its current valuation given the potential increase in earnings over the next few years. This of course in turn depends on the sustainability of the enterprise, management quality, potential market share increase and its ability to innovate over the next few years, to name a few critical “signals”. None of these are present in the first paragraph. Incredibly however most of the investors worry about all those things instead of being focused on learning more about the signal. They risk being drowned (literally) by the noise.

The level of “noise” also varies from time to time and some of the time the SNR is high and some time, low. However given the plethora of social and mainstream media currently on offer, the level of “noise” is unlikely to retreat to a lower level. If at all with the increase in means of communication and the tools available to all investors, it is a safe bet to assume that the level of “noise”, can only increase.

Can a rational (a fictional character) investor be expected to be able to keep focus on the signal instead of getting distracted by the “noise”? Surely a good test for any investor at any period, regardless of if the SNR is high or low, even if such a ratio was made available.

There is a popular phrase “Don’t just sit there, do something!” but in investing, especially longer-term equity investing, the reverse is true if you believe in creating serious wealth, “Don’t just do something, sit there!”. But as anything in life, the more profitable thing to do is often harder, not because it is more difficult, or complicated, but it goes against a human tendency for activity. Many people confuse activity with doing something useful. The best investment returns often come from making a reasonable bet and sitting on it for a long time.

However, reality is not that simple. It needs a little more explanation...

"The stock market is a device for transferring money from the impatient to the patient."

- Warren Buffett

So, how to ignore the noise?

Stop the browsing!

Many argue that investing in the earlier era was more efficient since information was not freely available and hence detailed dedicated research would yield real winners. Others argue that markets were not as complicated as they are now and hence were more amenable to longer term hypotheses to work over a period. In modern times the threat of disruption and the constant change that we see in corporate strategy and technology induced imperatives lead many to believe that the longer-term paradigm will not be successful. The jury is still out on the same but here is what the investors need to focus on even in this increasingly manic and complicated world.

• Understand that more information does not add to the investment case being right – A rough hypothesis is all that is needed – to be revisited and kept tabs on

• Too much analysis leads to paralysis. While this is a convenient heuristic, it has a grain of truth in it. Try and understand the investment rationale if it can be put in a few sentences. If you can, that may be enough to act on, reasonable caveats notwithstanding.

• Try and ignore “Breaking News” broadcasts and spend more time on company results calls and reading the financial statements, especially notes to accounts. This may prove more beneficial than trying to jump to the next “hot” story

• Reduce the number of stocks you can reasonably “cover” and let the rest be the ones that “got away”. Be honest, one cannot catch every winner

If one can follow these reasonably prudent set of actions, one can greatly improve the signal-to-noise ratio for our own portfolio

Can one hope to increase the signal-to-noise ratio?

There are significant ways to increase the SNR if one is a resolute and serious investor, capable of ignoring the noise. The ratio in a sense is a personal one. Not a generic one that applies to all in the general case. Only you as an investor can ignore or reduce the level of noise, not reduce the noise itself.

And once you have that ability you are on your way to a long and lonely path to wealth.

Happy investing!

[1] Source: Google AI Overview on the keyword “signal-to-noise ratio”

“Never invest in any idea you can’t illustrate with a crayon.”

- Peter Lynch