Signal and Noise in Investment

Investors have different styles. Theorists burrow business while emotionalists drill products. Jinjian Zhang has a unique investing style by positioning between the two opposites. He delves into sociology and demographics, as well as establishing his own methodology of reading people. He is among the most impressive investors I have met in recent years.


This year, two of the investments that Jinjian Zhang led are listed on NYSE. I hereby invite him to share his philosophy in investment. The speech impressed me more than most other sharing this year and I believe that you will undoubtedly be astonished.


We are living in an era that noise grows with explosive information. If every five year is identified as a life cycle, we can see inside the full picture of growth, decay, and various changes.


The accomplishments of human beings today are a result of focus, instead of collecting discursive information. Focus helps us filter out meaningless information and concentrate on the present moment.


During my seven years of undergraduate and graduate study, I focused on the research of identifying signals and noise. Basically, a filter was utilized to remove noises and capture the signal. Later, I applied the methodology to investments and found it highly compatible.


1.Identifying Signal and Noise


The following pictures are excerpted from my published paper in a magazine under the Chinese Academy of Sciences. I conducted the research of identifying cars in deserts. By analyzing the geosynchronous satellite images, we tried to spot the broken-down cars and rescue those trapped in the desert.


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You can see in the paper that each picture has yellow frames. The frames represent the identified cars. For example, in the first picture, the frame is a car along a road in the desert. The car images occupy no more than twenty pixels, most of which only have fewer than ten pixels.


What does it mean? It means that in a HD photo with millions of pixels, we need to capture the signals with no more than twenty or even ten pixels.


Life works the same. In a boundless desert of excessive information, we try to seize a microscale of signals, which have paramount meanings. This is what we have persistently studied and reflected in investment.


I had limited investment knowledge when I started my career in the field in 2012. Like most fresh investors, I buried myself in seller reports from China International Capital Corporation, Morgan Stanley, Goldman Sachs, etc. I categorized the information in reports into supply chain, demand forces, distribution channels, etc. The parameters increased from five to a dozen, or even over fifty.


I found the surge in the number of parameters as the knowledge of industries accumulated. I paused at the moment because I perceived the potential malfunction. I learned from the past seven-year scientific research that – differences gather in noise but similarities converge in signals. 


When you learn something new and find it becoming increasingly challenging and trivial, congratulations, you are collecting noise. In contrast, if you see the knowledge becoming concise and converging, you capture the real signal. It is the One by Lao Tzu – In TaoTeChing, “Tao produced One (reason of being), One produced Two (yin and yang), Two produced Three (yin, yang, and the production of their collision), Three produced everything). 


My tutor always said that noises show differences, but signals demonstrate similarities. A single realization of a typical noise, such as white noise, is a random shock. However, the summation of random processes will have Gaussian distribution.


Therefore, we should never study something from one single perspective. Or, you will be drowned in a flood of parameters.


Here is an example of my roommate. 


My roommate once secretly loved a girl. Luckily, the girl also had a secret crush on him. One day after a ball game, the girl came to him and asked, “Are you hungry? I bought you some chips.” Normally, people would take the words as a signal.  


However, my other roommate, out of the spirit of brotherhood, said, “The chips are on sale recently. You just got it!” My poor roommate was misled by the information and missed the real signal sent by the girl.


At the moment, signal and noise were mixed up and my roommate got a meaningless “wave band”.


Therefore, sometimes we complain why we did not receive the signal, why we failed to find the world changing, or why we did not realize that a company was in fact a unicorn. Essentially, the reason was not our missing out the signals, but was the “terrible friend”, the source of noise, continuously feeds you various Gaussian noise.


How to identify the noise? You have to constantly stay in observation and perception. Finally, when the source of noise disappears, you will have the opportunity seize the real signal. In my roommate’s story, if the source of noise – the second roo

mmate I mentioned – were removed, my roommate would have probably started the relationship with the girl.


2. Signal and Noise in Investment


Back to investment. What are signal and noise in investment?


Some people say that five years is a business cycle. From this perspective, what keeps changing and what remains unchanged in a long run? What needs reconsideration every five years? What has the least noise? 


The first signal I found in investments is demographics.


In 2012 to 2014, I spent entirely two years studying the global demographics of different countries, during different periods of time, and at different specific points of eras. It was not until the end of 2014 that I found that all the previous research was nothing but noise.


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To be specific, regarding the population structure of the four countries illustrated in the picture above, you will find one feature in common – fertility faults.


For example, China had two population booms. Japan had experienced two similar booms. The phenomenon can be seen beyond Japan and China. Germany, Russia, and if further, Poland and South Korea, all had population booms.


Why?


Because they were all belligerents in the second World War. Perhaps the war consumed a generation, or perhaps to prepare for the war, people started to create lives. Or, suffering from a war defeat, people had nothing to do at home but reproducing children. 


Take a look at Japan. The population structure of the country in 2000 is very similar to that of China in 2020. How can the population structure of a country in 2000 be similar to that of another country in 2020? Theoretically, if the population structure was affected by the engagement into the second World War, the similar structural features should have fallen into the same period of time. What caused the “delay”?


It was because Japan overestimated its power when the country initiated the war. After they swiftly occupied China’s three northeastern provinces, the authority proposed a 100-million population plan in 1939. It was believed that the Japanese population at that time were not sufficient to colonize the whole China. Therefore, Emperor of Japan stoutly encouraged the people to reproduce. In other words, before the end of World War II, Japan was united in a vigorous movement of “creating human”. However, in China, it was not until the ten years after the end of World War II did the government commended “Hero Mother”. It postponed the population boom for 20 years later than that in Japan.


Therefore, the same war had enormous but different impact on countries, in varied ways and phases. Usually, we ignore the rustling wings of the butterfly, the aftermath of which in fact has intimate connection with our life.


China legalized the constitutional right of birth control in 1978 and added it to the basic state policy in 1982. Do you know what it means? It means that nearly all the children born after 1983 were the only child in the nuclear family. The only child was free from confrontation and fight against siblings. It means that the concession, compromise or adhesiveness resulting from the confrontation with human nature could hardly be seen in the only-child generation.


Any further implications?


Yes. The post-1983s generation had big EGO when we had our first jobs. What would happen among the egotistical generation?


After the post-1983 generation reached 22 years old, which was 2005, hawkers and vendors emerged in China. Taobao started to have its clusters of active sellers. They found it hard to adapt to the shared working environment. They needed an independent space in an acquainted environment. 


Meanwhile, another interesting data emerged simultaneously – from 2005 to 2017, China’s divorce rate nearly tripled.


Prior to 2005, the divorce rate was basically steady with a slow growth. Between 2000 and 2005, there was even a decline. However, after 2005, the post-1983s began to enter marriage. Many people could hardly accept the life of living or comprising with a person with distinct personalities. 


Hence, the process has seemingly little connection with us, but in fact assembled everyone. As investors, we invest in the frame of times. What we see is not a single dot or slight changes, but the entire era and its entire orderly proceeding track.


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Take a look at another country – India.


If you take a close look at India’s population structure, you will find it ridiculous. From the chart, you can see little evidence of India’s participation in globalization. Whether World War I or World War II, globalization or WTO, did not stop its population from steady growth steadily. There was no faults or changes.


Therefore, we have a question when we invest in Indian companies – what exactly do you invest in? The question includes sub-questions, which are frequently raised by investors: Who are the clients? Do you really understand your clients? When were they born and what happened in that year? What was the social context of his growing? What personalities will be formed and what are the characteristics?


On the surface, everyone is different. However, from the angle of era, everyone has a lot in common. When invest, we need to go back to the core: identify similarities instead of differences.


People may ask how strong connection it is between population structure and economy? Are the similarities and differences in the connection meaningful in the domain of science? Can they guide your investment methodology?


To answer these questions, I did vast demographic research and read piles of books. Here I recommend The Demographic Cliff written by a well-respected demographics scholar Mr. Harry S. Dent. He is a remarkable American demographer. He has extensively studied the American population structure and found out that similarities outweighed differences in American families. He concluded the similarities in a line graph.


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The chart indicates that kids from average American families wish to buy the first apartments at the age of 26; they want a transitional house at 31, and a better house at 42. At 46 years old, they hope to have better furniture and afford their children’s college tuition.


He found through a large number of statistics that in the American population structure, the age of 46 witnesses the peak of average household consumption. It means that if we push forward the birth index, which includes immigration, for 46 years, we will see the predictable expenditure peak of an average American family.


Before that, let’s review the trends of baby boom. It began in 1934 and the birth rate began to accelerate in 1937, peaking in 1961. Based on the peak-at-46 assumption, the peak value of expenditure appears at 46 years after the birth boom. It means that a huge wave of economic prosperity can be seen from 1983 to 2007.


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After making the hypothesis, Harry Dante checked the Dow Jones Index and surprisingly found that data perfectly matched the prediction. Therefore, to us, something seemingly irrelevant in fact are unexpectedly connected in the whole picture.


In fact, there are a lot of subdivisions. If you look at the economic data of various countries around the world, study their population structure, fertility rate, marriage rate and divorce rate, you will find many occasions connected.


It is like the “Fourier Transformation”in Alan V. Oppenheim’s book Signals and Systems. In“Fourier Transformation”, any wave can be decomposed into the superposition of different periodic functions. There must be some small cycles in life that affect your life, but what are the large cycles? We are going to identify the big signals.


Today, food delivery platforms such as Meituan and Ele.me are expanding. People try to explain the reasons why food delivery could burgeon in China from various angles, such as the rise of micro-payment, the popularization of smartphones, and the penetration of WeChat electronic red envelopes. It all boils down to one thing – the impact of technological structure on human.


Have your ever thought about the impact of population and social structure on us? We can return to a question that without the technological development today, or without smartphone, electronic red envelops, micropayment, would we have food delivery business? Let’s look at the case in some developed countries to see if the countries have undergone similar processes.


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Take Japan as an example (because Japan’s data is very complete and time is sufficiently long).


The chart above shows the growth of all sub-categories related to dining in Japan from 1963 to 2007. Two lines ascended rapidly between 1963 and 1990. The figures were multiplied by 14 and 12 times respectively. One of the two lines is “Cooked food”, which is the bento culture in Japan today, and the other is “Meals outside the home”, which is dining out at restaurants.


Therefore, in the age without smart phones, the two fastest-growing categories of catering consumption in Japan were unexpectedly to be takeaway and dining out. What was the reason? The technological structure or the emerging of delivery men? Now we can look back to the transformation of social structure in Japan from 1963 to 1990.


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According to the data in the figure, during the 20 years from 1970 to 1990, the proportion of single- and two-person households in Japan rose by 9.8%.


You may suddenly realize the reason why you order food online today is because you live alone, or you only have your girlfriend or wife at home. In fact, people having a family can understand that when you live with your child or old parents, you are not willing to order takeaway online.


Usually we see a revolution as a result of technology. However, in fact, it is the result of unperceivable transformation in social structure, which grow up with the increasing divorce rate and single status. The rapid expansion of the proportion of single families and Dink families squeezed out a demand based on food delivery and dining-out. The demand has expanded by 14 and 12 times in the past two decades in Japan. In contrast, during the same time period, the consumption index of Japan only increased by slightly over 7 times.


When investing, we start with the thinking of revolution caused by technology. However, we should trace back to the origin of signal. What changes are undergoing in population structure? What will be generated by social structure transformation? What does the increasing number of single people imply? What is the real signal? The answers are all well-rooted in the signal.


3. How to Respond to the World of Noise?


Here is another question:  how can we utilize the signals in a society driven by demographic and social structures? What exactly is the theory of signal and noise?


I think that I am definitely not the first person to draw correlations among these factors. Someone in the world must be thinking about the theory of signal and noise as well. Many excellent product managers and entrepreneurs are using the method to create products and business models.


I tried to find supporting evidence and intersected points in the field of economics, and finally I found Fischer Black. Fischer was a legend on Wall Street, the author of the well-known Black-Scholes-Merton options pricing model. One year after he passed away, the Nobel Economics Prize was awarded to the other two living co-authors.


Fischer invented many pricing and quantification methods in his lifetime. The methods have become the basis of modern finance. Based on the methods, he published a paper of Noise, 8 entire pages to elaborate noise in the field of finance. 


He wrote in the paper that value investors cannot prove their capability in a short period of time because the world has many noises. The noises urge some noise traders to make deals in noisy environment. Consequently, the deals themselves become a source of noise, which further affects more noise traders. Eventually, the society becomes the confrontation between value traders and noise traders.


Most of the time, there are way more noise-traders than value-traders. Therefore, stock prices may fluctuate quickly in a short period of time but the direction of the fluctuation tend to be completely opposite to that of the value traders. At the end of this paper, Fischer asked a question: Are the noise traders worthless? His answer was NO.


It was exactly the noise traders that provide liquidity to the entire market that allows the market to develop in the long term. If everyone is a value trader, who will sell? Who will buy when others sell?


Therefore, in life, do not worry about the noises or the words like “Your competitor’s startup has raised one round of financing within 3 months” or “While you are stagnated in thinking, you find him have other three rounds of financing within a year”.


Too much noise scatters around the world. Noise is everywhere in your life, career, and everyday networking. I hope that you will not be changed by them because they are nothing more than noise.


If you follow Fischer’s theory, you will find that the stronger the liquidity in a system is, the more noise there will be. Every technological revolution has pushed the world onto a higher level of liquidity.  In the past, we thought that the Industrial Revolution has brought about an increase in liquidity, but later we found it nothing if compared to the Information Revolution.


When we think that the current efficiency of the information and assets flow has been raised high, the emergence of blockchain technology will eliminate the significance of the previous liquidity. In the future, the blockchain revolution can convert everything into liquid assets, which will beyond your imagination.


In this era of growing noise, how do we invest and start a business? Based on the understanding and research on signal and noise through these years, I can share with you three principles:


First, be open-minded. 


In this day and age, you must remain sensitive to changes worldwide. When the noise grows, more sensitive radar may be needed to capture the signals. Therefore, you will find that lids (receivers) are becoming flatter and larger in diameter – the design allows it to catch more tiny changes.


Therefore, no matter what position you are in, be radically open-minded.


Second, stay in perception.


Signals will never crop up at your door. Like the example of my roommate in the beginning: although the girl was the most important signal of his life, there were problems in the transmission of the signal. He missed a real signal from the very beginning but thought the terrible friend as your best mate. The disturbing noise was not removed until they were apart after graduated.


Therefore, throughout your life, you need to stay in perception. Only by long-term observation and understanding of signals can you one day capture the signal that really belongs to you.


Third, discover the changes.


A single realization of a noise is random and discrete. However, if spread over a long enough time series, noise is normally distributed with a zero mean. Therefore, only to discover these changes can you find identify the most valuable signal in your life.


I have benefited tremendously from the research method. Hope that the method, in this highly liquid and noise-filled world, can help you become an excellent filter to filter out noise in life and find the real signals.