Signal vs Noise

February 23, 2018

For those of you who have fallen behind in your electrical engineering reading, one of the major elements of that field is signal processing. A fundamental problem in signal processing is knowing what is in fact signal, and what is noise. That music through your radio? That's signal. The static? That's noise. Unless it's what my kids listen to, in which case the two are indistinguishable.

It's not just electrical engineers who are faced with this problem (sometimes noise can even add signal).¹ All day long your mind tries to determine what inputs are signal, and what are noise. This becomes more difficult as you have less experience with a field, because you have no basis or experience from which to form judgments. So you are more easily influenced. This happens to all of us.

For example, I don't know a lot about offensive line strategies in pro football. I know that if you under-inflate the football you are probably going to end up in the national news. I know that if you over-inflate the football, you won't get that level of attention, though I'm not sure why you would do that from a physiology perspective.² You could make an argument to me that one strategy is good, and I would nod approval, and then you could make an argument that a counter strategy is good, and I would also nod approval. I have no way to find the signal.

This is an acute problem that the public faces in investing. Finance is a complex field that most people do not have the time or inclination to focus on. Trying to filter out "who is right" is an exercise that easily can be derailed by 1. advertising 2. local people selling financial products 3. human mental tendencies, such as overweighting recent events or statements.

A classic pushback that I hear from the traditional investment industry, when a client queries them about index funds, is "There isn't a right way or a wrong way. Our strategies are just different." To which my natural reaction is well let's stop working then, sing Kumbaya, and dance around a Maypole.

On a more serious note, we're going to help with this. We'll be updating our web site with more information to draw out the differences between indexing and other strategies. In the meantime I have a suggestion. If you're trying to make a decision, research how people get paid in the financial business. I had an accounting professor in college named Uwe Reinhardt. He was fond of turning up scandals, and he would say that if you want to understand something, follow the cash flow. The cash will tell you a lot about people's incentives.

Our fee structure can be expressed in one sentence. Many of our competitors have fee disclosure documents that go on for pages and pages. It brings to mind something Warren Buffett once said: "I like to deal with people where I feel a one-page contract would do the job. If I have to have 50 pages to protect me against the guy I’m dealing with, I’ll always wonder if I needed 51.”

Dan Cunningham

1. http://www.ele.uri.edu/faculty/kay/New%20web/downloadable%20files/00809511.pdf
2. http://theconversation.com/football-physics-and-the-science-of-deflategate-36581