Filtering Methods
Taleb compares separating market information from noise with filtering static from a telephone signal. The analogy highlights the risk of treating fluctuations as meaningful changes.
THE IDEA
Filtering Methods
Engineers use methods to clean up the noise from the signal in the data. Did it ever occur to you while talking to your cousin in Australia or the South Pole that the static on the telephone line could be distinguished from the voice of your correspondent? The method is to consider that when a change in amplitude is small, it is more likely to result from noise—with its likelihood of being a signal increasing exponentially as its magnitude increases. The method is called a smoothing kernel, which has been applied in Figures 11.1 and 11.2. But our auditory system is incapable of performing such a function by itself. Likewise our brain cannot see the difference between a significant price change and mere noise, particularly when it is pounded with unsmoothed journalistic noise.
When to use it
Examining how filtering changes the interpretation of market-price data.
Assessing measurement noise and the assumptions used to filter experimental data.
Distinguishing meaningful feedback from random criticism in performance reviews.
Filtering irrelevant news from key developments in strategic planning.
FROM THEORY TO EVERYDAY LIFE
In practice
Telephone static vs. voice
A telephone signal contains both voice and static. A filter attempts to reduce unwanted components while retaining the voice; how well it works depends on the properties of the signal and noise.
Stock market fluctuations
An analyst smooths a series of daily prices to examine slower changes. The smoothed series is another view of the data, not proof that its remaining movements represent a meaningful trend.
A MOMENT TO REFLECT
Put it to work.
Recall a time you interpreted random noise as a meaningful pattern. What assumptions would you need to check before applying a smoothing method?
How might you apply a filtering mindset to a current decision under uncertainty?
In what areas of your life are you most susceptible to mistaking noise for signal?
CONTINUE THE CONVERSATION
Source texts
- Fooled by Randomness The Hidden Role of Chance in the Markets and in Life (Nassim Nicholas Taleb)