Sunday, March 27, 2016

Time Horizon Bias

I've been reading and thinking about the kinds of systematic mental mistakes people make.  I've just come across an interesting piece in "Fooled by Randomness," by Nassim Taleb.  

Checking results of a measure (like stock prices) frequently, increases the ratio of negative (price down) vs. positive events (price up).  This is due to the existence of randomness (volatility in stock prices).

Because there is a good deal of day to day randomness in stock prices, at short time scales the volatility masks the trend.

So while a stock price can in general be trending up, the trend can be hard to discern at short time horizons.

If it's true that people feel more pain from a loss than pleasure from a gain, this means that checking frequently can lead to an overall feeling of loss, even though in dollar terms there is a gain.

Example: 15% Return with 10% volatility (uncertainty per annum)

This translates into a 90% probability of making money in any year

  • Checking daily: this means 241 pleasant minutes against 239 painful ones each day (8 hour day)
  • Checking monthly: 8 pleasant events versus 4 painful events
  • Checking yearly: 19 pleasant events to 1 painful event

Viewed more generally:

  • Over one second, 1796 parts noise for one part performance
  • Over one hour, 30 parts noise for one part performance
  • Over one month, 2.32 parts noise for one part performance
  • Over one year .7 parts noise for one part performance
Of course, one should be monitoring the overall trend, as the example above assumes that you are getting a 15% return.  Since the trend can only really be discerned at longer time horizons, it begs the question, what is the appropriate time horizon to check, as you not only want to maximize your feelings about the stock, but you also want to maximize your gains.

So what do you think?  Ready to stop checking stock prices every day?

#Randomness #Happiness
Fooled By Randomness Web Site
On Google Books