Wall Street's Dumbest Metric


In Nate Silver's new book The Signal and the Noise, the young statistician attempts to separate the wheat from the chaff in the wide world of predictions.

Silver's main point is that we often confuse the noise (distractions) for the signal (the answer), which is why so many predictions in a diverse array of fields fail. Silver is most famous for taking on the political punditry establishment by predicting a comfortable victory for Barack Obama in this year's election. He was pooh-poohed by a number of commentators who said the race was much too close to call, but in the end, of course, Silver was right. His mathematical model predicted the winner of all 50 states, giving President Obama victory by more than 100 electoral votes, while the pundits, whose claims were based on nothing but hot air, were left to eat their words.

Though it was Silver's takedown of the political forecasting universe that brought him into the limelight, his insights can be just as useful in the financial world. As investors, we struggle to separate the signal from the noise. What led to one stock's rise may not prove the same for another. We are inundated with media, and any number of strategies for making picks, such as fundamental analysis, technical analysis, or mechanical investing. Unfortunately for us, predicting the stock market is much more difficult than predicting the winner of the next presidential election. Silver simply looked at polls and their accuracy in past presidential elections, which gave a sense of the predictability of those polls, and built his model accordingly. In investing, there are no polls. We would all like to know the future price of a stock, but that is largely based on future events, which of course are unknowable until they happen.

So it may be impossible to detect the signal in investing, but there is still plenty of noise we can eliminate. And one of the most egregious offenders, in my mind, is the endless reporting of the "most active" stocks of the day -- those with the day's highest trading volume. This figure is prominently reported on websites such as Yahoo! Finance and The Wall Street Journal, as well as on business news programs such as PBS' Nightly Business Report.

The most active list appears to provide important information for investors. By telling us which stocks had the highest trading volume, it presumes to inform us that there was big news surrounding these stocks on that day or that they were particularly "hot" for whatever reason -- maybe a large investor dumped a lot of shares that day.

However, scanning this list reveals many of the same stocks day after day. Bank of America , for instance, almost always tops the list. Other usual suspects include Ford , Facebook , and Sirius XM Radio. Like other timely pieces of information, the list's repetitiveness underscores its uselessness. If the weather report is the same every day, then we don't have to pay much attention to it.

The market, however, is anything but repetitive. The problem with the "most active" list is that it's subject to two major biases: It favors stocks with low share prices and high market caps. Essentially, the more shares outstanding in a stock, the more likely it is to be considered "active."

Take Bank of America, for instance. The company is a behemoth, worth over $120 billion and the No. 2 bank in the country by assets. Yet its shares trade for only $11. No other U.S. stock with a market cap of $100 billion or more has a share price anywhere near that low. GE comes closest at $20. Moving down the largest-market-cap list, Ford is the closest at $12. It's no surprise that the carmaker is also a regular on the most-active list. In fact, all five companies mentioned rank in the top 25 for total shares outstanding, and Bank of America tops the list, which helps explain why it's often the most active in terms of share volume.

Of course, volatility plays a role also. There's a reason that Procter & Gamble is less active than Facebook, despite having more shares outstanding. The defensive investors who tend to invest in paper towels and shaving cream are less active traders than those who buy and sell shares of the world's largest social network, which has also been one of the most intensely debated stocks of the year.

A better way
All but the most beginner of investors know that the price of a stock on its own tells you little. Neophytes tend to assume that Apple and its triple-digit price tag mean the company's shares aren't as good a value as Sirius XM, considered a penny stock, but that's not true. Valuation ratios such as the P/E are the real indicators of how pricey a stock is. There are times when actual share price is relevant on its own, but in general, it's mostly noise, as is the list of most active stocks and stand-alone volume.

Below is a short list of suggestions for ways financial outlets can improve investor understanding of volume and the day's most active stocks.

  • Instead of simply reporting the number of shares traded, tell us how that compares to the average trading volume. If my stock's trading volume is four times its average on a given day, I'll know that it's probably worth reading up on that day's news.

  • Similarly, instead of telling us just the number of shares traded, I want to know what percentage of shares outstanding was traded that day. This will give me a better sense of how much of the stock actually turned over that day, and how much turns over on average. This figure plays a big role in bid/ask spreads, which will grow tighter as trading volume goes up. It also affects short squeezes.

  • Finally, instead of telling us the most active stocks in terms of number of shares traded, tell us the most active in dollar value as well. That way a stock like Apple, which remarkably still has more than 20 million shares change hands every day despite its $500 price tag, will be appropriately recognized as the most widely traded stock. Over $10 billion in Apple stock gets traded on the average day, far ahead of the $1.5 billion in Bank of America shares changing hands daily. That helps gives you a sense of the iPhone-maker's importance in the stock market, and makes the current "most active" list look like a distortion. No wonder Apple dominates financial news coverage.

Foolish takeaway
It's often the little things that make us better investors, and knowing what information to ignore can be as valuable as knowing what to follow. As Silver says in his book:

Information is no longer a scare commodity; we have more of it than we know what to do with. But relatively little of it is useful. We perceive it selectively, subjectively, and without much self-regard for the distortions that this causes. We think we want information when we really want knowledge.

For investors, in this era of digital media and high-frequency everything, separating the signal from the noise is more important than ever.

Despite investors' wishes, Apple still plays by the above rules. We would like the glut of information on the company to be easy to decipher, but that's anything but the truth for the world's most valuable public company. Get an in-depth look at the hard data behind Apple's future in our new premium research report all about the tech titan. This isn't the spin you're used to seeing in the financial media. It's deep research you won't find in other outlets, detailing the company's opportunities and risks with analysis and charts to help you understand the whole picture of Apple's future and potential. You can get your copy of this new premium package now. All you have to do is click right here.

The article Wall Street's Dumbest Metric originally appeared on Fool.com.

Jeremy Bowman owns shares of Apple. The Motley Fool owns shares of Apple, Bank of America, Ford, and Facebook and has the following options: long JAN 2014 $20.00 calls on Facebook. Motley Fool newsletter services recommend Apple, Ford, Facebook, and The Procter & Gamble. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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