In your most recent book, Noise: A Failure of Human JudgmentDaniel Kahneman, Nobel Prize winner in economics and one of the world’s leading experts in behavioral economics, highlights two types of errors in human judgment: bias error and noise error.
Bias error causes judgments to systematically deviate from the correct answer. A biased judgment may be accurate and have low variability, but it will always be wrong.
On the other hand, the noise error makes judgments about the same case lead to very different answers. A noisy judgment may eventually give the right answer, but it will often be wrong.
As the title itself indicates, the book by Kahneman and his co-authors, Olivier Sibony and Cass Sunstein, shows that there is a lot of noise in important decisions. This profoundly impacts people’s lives, such as decisions on medical and legal issues.
Of course, both types of mistakes are very important and should be avoided. But the main argument of the book is that noise in human judgment has been under-researched. Another important point is that noise error can be measured even when the correct answer is not known. That is, even when we cannot measure the bias error, we can get a good idea of the noise error and try to correct it.
Unlike other areas of human judgment, noise is a central theme in finance. When we invest in stocks, we have to decide what the future stock price will be. We already know that measuring the bias error of this decision is very difficult: in addition to the large number of variables that should be used, there is still controversy about which model should be used to calculate the future share price.
However, measuring the noise of this decision is much easier. In this case, the noise will be proportional to the volatility of the stock. Furthermore, we know very well how to mitigate it: we must diversify investments. In fact, the beneficial effect of diversification on portfolio risk is perhaps the most uncontroversial recommendation in the world of finance.
Despite the clarity of this result, many investors still do not diversify their investments. Therefore, try to avoid unnecessary noise and diversify your investments.
Fernando Chague (Professor of Finance at FGV’s São Paulo School of Economics) and the Why?
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