Narrative Fallacy in a nutshell.
As human beings, we love stories so much that we let our preference for a good story cloud the ability to make rational decisions. However, stories may negatively govern the way we think, that is we may be drawn towards a less desirable outcome simply because it has a better story.
The famous academic and financial trader Nassim Nicholas Taleb has defined this compulsive habit of connecting the dots between random events to grossly over-simplifies reality as “the narrative fallacy”. In his 2007 best-seller “The Black Swan”, Taleb wrote:
“The narrative fallacy addresses our limited ability to look at sequences of facts without weaving an explanation into them. Where this propensity can go wrong is when it increases our impression of understanding.”
The investment world
It goes without saying that, when considering the investment world, the narrative fallacy can enhance the risk that both retail and professional investors get overly attached to a particular story about the market. That can be clearly seen when investors pile into a high-priced investment, such as a well-known company, a hyped coin or a glamorous fund based on glossy magazine articles about its rags-to-riches owners, creators, or asset managers. Hence, a certain company on the news may well be innovative with a quotable and charismatic CEO and an emotionally resonant history. But do these characteristics make it a buy? This information about the company and its story is only worth something to you as an investor if you are exploiting something that the market does not already know. By the time companies or individuals are being hyped in the media, the market already has priced that story, and a strong story does not necessarily make a strong investment. Investors buy and sell various company stocks for several reasons, most of which have little to do with the daily news narrative. And even if the narrative continues, that does not mean that stocks will continue to move in the same direction.
Financial news and other instances
Narratives get attention. They fund science studies and attract charitable donations. They fuel political campaigns. They attract attention to financial news.
A title like “Wall Street closed sharply lower today as investors digested a warning from the Federal Reserve of a significant slowdown in global economic growth this year.” Although the warning is significant for future expectations, we cannot be sure that the FED report indeed caused the sell-off in the equity market. Positive or negative movements in the stock market cannot be explained by a single narrative. Market prices result from billions of shares of stock being bought or sold. Such volume has millions of causes, like the liquidation of several large portfolios, tax-loss harvesting and rebalancing or just a lot of random activity. It could also happen that the market was just looking for an excuse to pull back and the economic warning was a hook to hang it on.
A headline like “Stocks went up today and we have no clue why!” simply would not be catchy for the news, although it certainly would be more accurate than most of the popular financial news. In fact, it would be ideal to report that a whole lot of noisy and unrelated events occupied the attention of the markets today, most of which will be forgotten tomorrow and none of which will be relevant to anyone with an investment horizon measured in years.
Morevore, even if the explanation for today’s market move was correct, this would not predict tomorrow’s event and how the market will react to them. Investing this way, via stories, requires you to both anticipate tomorrow’s news and tomorrow’s price response.
Apart from financial news in which the power of narrative could be grasped on a daily basis, there have been major occasions in which the narrative fallacy played a role.
First, head back to the late 1990s when many people had assimilated the shared view that, since the internet and the digital economy were going to change everything, traditional accounting measures of earnings were irrelevant. A form of madness took hold as investors pushed the valuations of many dot-coms start-up to ridiculous levels: when it all went bust, another story had to be found.
Another example, well portrayed in the movie “The Wizard of Lies”, is represented by Bernard Madoff’s Ponzi scheme. The former Nasdaq chairman has been the architect of a major case of stock and securities fraud, discovered at the end of 2008. In the previous 4 decades, Madoff had managed to trick more than 4800 clients for a total of $64.8 billion. From the ‘60s he had been building a reputation as a wealth manager for a highly exclusive clientele. His clients gained access through word-of-mouth referral, believing that they had entered the inner circle of a money-making genius. Therefore, his fraud was not only fuelled by the fake returns he had achieved, but also by the narrative created around his figure by his clients and newspaper articles.
Finally, remember that stockbrokers have taken advantage of the narrative fallacy for years, convincing clients to invest in a particular stock by telling them a great story about the company. This can be easily seen in the following scene from “The Wolf of Street” in which Jordan Belfort and other brokers sell penny stocks with the help of finely orchestrated narratives.
What can we do to avoid falling victims to pretty stories?
As we have seen, both newbies and experienced investors can be seduced by stories. Once we understand our brain’s desire for narrative, we notice how we are surrounded by narratives every day, all the time, especially as we consume news.
The first way to deal with narratives is to simply avoid or reinterpret sources of information most subject to this bias. We want to use narrative to our advantage but also be aware that it can be misleading.
Another way is to start keeping track of decisions and predictions related to investments. The more you are able to do this exercise, the more you will understand how complicated cause-and-effect factors are when we look ahead rather than behind.
The final prescription, and probably the most important, is that, when searching for a worthwile investment, one must favour experimentation over storytelling and experience over history (which can be cherry-picked). Figure out what you know and what is a guess and become humble about your understanding of the past. Essentially, you are still creating a story through data, but it is your own story and would probably have a happier ending than under the other approach.
This piece attempts to present and explain the human tendency to spot patterns and weave everything into stories, with a look into the world of investments. Without a deep search for reasons, we would go around with blinders on, one thing simply happening after another. The world does not make sense without cause-and-effect. This necessary mental function serves us well, in general. But we also must come to terms with the types of situations where our broadly useful “ordering” function causes us to make errors. But, what if the concept of the narrative fallacy is just another compelling story we are telling ourselves? But that starts getting into brain-melting territory, so let’s just leave it for another time.
Marotta, D.J. (2016, Oct. 15). The Narrative Fallacy. Forbes. Retrieved from: https://www.forbes.com/sites/davidmarotta/2016/10/15/the-narrative-fallacy/?sh=4fa1f9d231bf
Risbud, S. (2019, Feb. 3). The Narrative Fallacy; Why you shouldn’t always trust success stories. Medium. Retrieved from: https://medium.com/the-post-grad-survival-guide/the-narrative-fallacy-9bb16c81457
Thaleb, N. N. (2007). The Black Swan. Random House Publishing Group
Unknown (2021). Avoiding Falling Victim to The Narrative Fallacy. Fs Blog. Retrieved from: https://fs.blog/2016/04/narrative-fallacy/
Wikipedia (2021). Retrieved from: https://en.wikipedia.org/wiki/Madoff_investment_scandal#Modus_operandi