Every enjoyable TV-series or chapter in a book keeps its viewer or reader in suspense for the next episode of the story with a nail biting cliffhanger of the excitement to come. Even low-quality TV-series can keep going for ages by allotting the full scope of the artistic work to the final part of an episode, just to lure the audience back for the next run. The element of surprise intrigues people and spurs curiosity, sometimes beyond reason and logic, to the level that you end up watching the last thirty-two episodes of Dallas or Chasing Cameron.
Still those last forty-five seconds, being the cliffhanger, are the ones that triggers your brain to come back for more, and time after time imbues you with the frustration that nothing played out as the cliffhanger suggested. You could call it “Netflix-volatility” with no reference to the stock traded on Nasdaq.
Let’s put this in a comparative context by comparing two TV-series in terms of quality and our proprietary “cliffhanger suspense factor”. We have compared the first four episodes of Breaking Bad against Chasing Cameron. In the chart below we can see that the differences in quality is reflected already in the first episode of the two shows but Chasing Cameron makes a relative huge quantum leap in terms of the “cliffhanger suspense factor” which triggers the audience to disregard the previous forty five minutes of a non-comprehensive screen play. Instead of discarding the next episode the viewer hopes for a change and returns for the next episode. The viewer extrapolates, in this case based on the “cliffhanger”, the future quality of the next episodes based on an exogenous and unknown factor. As for Breaking Bad you base your decision, to continue to watch subsequent episodes, simply on the fact that it is a high-quality show where the cliffhanger does not, to the same extent, affect your decision to watch or not to watch.
Think of the above as stock volatility and how that affects investor behavior. Both in terms of selling and buying stocks. The element of surprise is a strong force to be reckoned with which we often describe as a “black swan” or as lightning from a clear sky. When we do get surprised we tend to apply the worst or the best values of that surprise and base our future projections on those values without digging into our memory to analyze, at what speed and in what magnitude, signals, patterns or events that accumulated ahead of the “surprise”.
The stories in the stock market that we, as a quantitative researcher, like are very similar to a well written book or movie where you don’t need to be horrified, every quarter, by the unpredictable “volatility boogieman” if the ongoing story is a good one.
Our methodology is set on the premise that every corporation and its listed share has a story to tell. That story is written in the language of market prices which reflects the common knowledge of many ghost writers who, when they are confident in their writing and trajectory, do not need to add the nerve wrecking moments of unwarranted excitement to the narrative. I have exemplified this in the story of Pfizer and GM in the graph below. The dotted lines represent the volatility (cliffhanger) which is the right axis and the left is the performance (story).
The chart, and its components, illustrates well the kind of journey our methodology favors when picking stocks. Our assumption is that the more the market knows of a company’s history, short and long term, the lower will the magnitude of the surprises be, thus leading to a smoother and more tenable return stream.
Obviously there are scary exemptions to the rule; how we predict those for the future is something we will leave for our next story where we will talk about the Change-point Detection Algorithm.
André L. Havas