In August 2024, a weaker than expected jobs report sparked the most volatile day of the year in the stock market as investors extrapolated that higher unemployment would lead to a recession. In early September, lackluster manufacturing data sparked a similar selloff. And with a presidential election looming, every word out of the candidates’ mouths seems to influence the direction of the stock market.
At Leelyn Smith, we label these isolated, market-moving events as “noise.” Market noise is an unavoidable part of owning stocks and bonds, and it distracts from the true factors that contribute to building long-term wealth.
What is noise?
The term noise was developed in 1986 by noted economist Fischer Black[1], who stated that “noise” should be distinguished from “information” and that more trading occurred due to noise rather than evidence. Noise is reactionary trading driven by news and information that is often non-fundamental and speculatory in nature. We view trading on noise as the opposite of sound investing.
Noise has many potential sources including investors’ reactions to news coverage, economic and market data reports, and company-specific events like earnings and dividend announcements. Noise is especially prevalent during presidential election years as the media amplifies and interprets (often incorrectly) the potential outcomes of major political races.
Algorithmic or program-trading is another contributor to noise. These data-driven programs are trained to listen for and trade on key phrases in earnings reports, which exacerbate price fluctuations. As the volume of program-trading rises, market volatility increases.
Investors should be aware of the risks caused by noise and seek to limit its influence on their behavior, because it distracts, distorts, and creates confusion over the drivers of market returns. More importantly, it can take clients’ focus away from what should matter most: company and market fundamentals and the stock market’s long-term upward trend.
How noise appeals to our emotions.
While some financial publications present news in a balanced manner, many news outlets write headlines and slant stories to be provocative and entice readership. Social research has confirmed this “negativity bias” in reporting[2]. Such sensational coverage of periodic economic data and earnings releases, for instance, is meant to incite the two emotions that often lead to poor investment decisions: fear and greed.
At Leelyn Smith, we recognize that emotions are one of the greatest risks facing investors. This is one of the key pillars of our investment strategy, and it can be heavily influenced by noise. We counsel clients to ignore short-term volatility as much as possible because it can cause investors not only to panic when prices fall, but also to chase returns for the wrong reasons.
We also find that the prevalence of noise can cause clients to anticipate bad news and become anxious about future outcomes. Such scenarios occur frequently in election years as candidates make speeches and participate in debates while voters digest constantly updated polling numbers.
Tune out the noise and focus on fundamentals.
The greatest danger of noise is that it causes investors to abandon the discipline that supports long-term success. In musical terms, noise creates dissonance that upsets the harmony of the investment process. Being aware of noise and knowing how to deal with it can allow investors to maintain confidence in their plan and not become distracted.
A good way to stay in harmony is to understand that equity markets rise more than they fall over long time periods. Remaining invested through short periods of dissonance increases investors’ ability to capture the long-term appreciation that markets offer.
Regardless of how noise makes you feel about the economy and financial markets today, the fact is the current macro picture looks very solid. Leelyn Smith’s Chief Investment Officer Brian Dorn explains that stocks perform best under four conditions:
- Strong economic growth
- Rising corporate profits
- Declining interest rates
- Low inflation
With inflation coming under control, interest rates declining, and the odds of a soft landing for the economy increasing, we are currently meeting most, if not all, of these conditions. This is the information that should guide long-term investments.
While noise is often a distraction, clients with a disciplined financial plan and investment approach can also take advantage of short-term volatility. Leelyn Smith does this by actively managing client portfolios and using noise-induced declines in high-quality stocks to buy at attractive prices, a process that can improve risk-adjusted returns over time.
With election day just weeks away, you should expect to be continuously inundated by noise. Resist the temptation to let it derail your investment goals.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Investing involves risk including loss of principal. No strategy assures success or protects against loss.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
[1] Black, Fischer, “Noise,” The Journal of Finance, July 1986.
[2] Reputation Sciences, “Understanding the Negativity Bias in News Media,” October 2, 2023.