Stories have long been fundamental to the human experience – they are vivid, coherent and memorable – and are crucial to how we interact with the world.
Stories cater to our need for sense-making [ii] and our desire to observe causality. In one form or another, they underpin most human decisions.
One particular model of decision-making – the explanation-based theory – emphasises that in certain conditions, individuals start their decision process by developing a causal model to explain the available evidence [iii] – to rationalize it, in other words, and put otherwise potentially abstract data into context.
In fact, investment decision-making is a domain in which stories assume a particular importance in driving, informing and justifying conclusions. There are two key reasons for this:
Complexity: Narratives aid our comprehension, or, at least, can lead us to believe that we understand something... Stories are therefore important in allowing investors to both simplify and justify decisions.
Uncertainty: Financial markets suffer from profound randomness and unpredictability. Our surest means of coping with the discomfort is to manufacture meaning by forging a relationship between the data and an explanation – a story, in other words – of why the data is what it is and how it got that way– what Taleb refers to as the ‘narrative fallacy.’ ... Our focus on narratives leads us to hugely understate randomness and chance, and is a major driver of some of our most damaging behaviours.
The perception still holds that news and narratives drive price fluctuations, when the causation is typically the reverse. We struggle to comprehend that asset prices often move in a random or unpredictable fashion, therefore we must attach some explanation to it. The more regularly an asset is priced, the more narratives that will be linked to its behaviour – for frequently traded, market-priced assets, most investors have little hope of escaping the swarm of narratives.
There is a close association between how we use narratives and the notion of confirmation bias.... It is not simply that we ignore or certain types of evidence, it is that we can shape a narrative around a particular piece of evidence so it concurs with our own preconceived idea – in this way, two individuals with polar opposite views can use the same evidence to support their conflicting positions. This type of behaviour is particularly prevalent in financial markets because the level of uncertainty means that there are always different and (seemingly) valid explanations.
As well as creating our own narratives, we are also captivated by the stories of others. Stories are engaging, compelling and persuasive;
If we return to the opening quotation from Robert Shiller’s work on ‘Narrative Economics,’ he notes that narratives are “mixtures of facts, and human emotion, and human interest and other extraneous detail.” To that we can add that the types of narrative we create for ourselves will be based on factors such as our character, experience and incentives – not necessarily just the objective facts before us. The problem is that for many compelling investment stories, facts are often only a small dose in the overall mix of contributory elements.
Most of us won’t make an investment decision without it being supported by some form of story, and that’s understandable; stories are effective and can be very valuable. However, we must also take the time to consider the credibility of the narrative, the data that underpins it and our own role in shaping it.