The Narrative Fallacy
Human beings crave a narrative. It allows us to make sense of the complexity that exists in all aspects of our lives. According to Yuval Noah Harari, author of the acclaimed book Sapiens: A Brief History of Humankind, storytelling allows us to cooperate on different tasks by having a shared belief about things like money, religion and government. Think for a second about the money in your wallet. Why can you exchange that for a good or service? It is because the business on the receiving end knows that it can use that money to pay employees or buy more inventory due to a shared belief in the value of the currency. As constructive as narratives are in certain areas, they can be potentially destructive when it comes to making decisions with one’s investments. This way of thinking leads us to deterministic conclusions about past, current and future events that impairs our ability to process information from an objective standpoint.
We’ve all heard that hindsight is 20/20. Seeing the past in crystal clear vision could do more to cloud our perception of reality than it does to help us understand the way things are. For example, I often see an advertisement for a stock-picking service that promises an idea that is “like buying Amazon in 1997.” Veracity of their claims aside, I think, “fantastic, sign me up for the 95% drawdown in four years” (see below). We all know the behemoth that Amazon has grown into today but holding on in real time as it transformed from online book retailer to its current form would have required nerves of steel. What’s missing from any backwards-looking analysis is the impact of chance. We potentially overestimate the probability of an event because that’s the way it happened, and it makes the narrative of our current situation flow. Our narratives will tell us that these companies were a sure thing, that they were destined to become great when, in fact, there was (and still is!) a lot of uncertainty. Avoid looking for the next big thing that is a sure bet because it just does not exist.
Another common tendency is to take a current situation and either extrapolate it or assume a reversion to normalcy, whatever that is. A good example of the latter is the notion of a “rising rate environment” that has been potentially around the corner for quite some time. It’s hard to fault this line of thinking as higher rates have almost seemed inevitable the lower that rates go. Reversion to the mean can be a powerful force but unfortunately there is no definitive answer on what that mean is or when any sort of reversion might happen. On the flip side, the recency bias tells us that recent events should continue indefinitely into the future. Going back to the tech bubble, many people were convinced that this was the “new normal” and that adding dot com to the end of a business name meant untold prosperity. As it turned out, things like earnings and profits eventually mattered and the focus shifted to finding undervalued companies that generated positive cash flow. Getting caught on the wrong side of either of these narratives led to almost guaranteed subpar performance.
So far we have seen the difficulty in crafting a narrative that fits readily available current and historical data. What happens when we add a variable like future events? Not only do you have to be correct in your prediction of Event A happening, but decisions with your money are going to be graded according to how the markets react to said event. I hope you can see the degree of difficulty to which this exercise got raised. With that in mind, think ahead to Tuesday, November 3rd. Election Day carries a lot of weight in the minds of many people. Regardless of the candidate or party you are backing, the market cares not. It goes through cycles just like the economy and a president either benefits or does not based on timing and factors out of their control. This paragraph may have stirred some strong feelings in readers on both sides of the aisle. Politics tends to do that. As I mentioned in my last blog post, Rule #1 of investing should be, “don’t get emotional about your investments.” An addendum to that might include, “especially if you are peering into the future.”
Alexander Hamilton said, “I have thought it my duty to exhibit things as they are, not as they ought to be.” So often we paint our perspective of past, current and future events with what ought to be that we miss what is. Keeping a level head and focusing on the long-term is a surefire way to improve your prospects. Looking for blind spots in your narratives improves on that.