The Dangers of Storytelling in Investing: How to Avoid the Narrative Fallacy

Imagine explaining why a leaf fell from a tree at 3:42 PM on a Tuesday.

Was it the wind? The age of the leaf? A butterfly flapping its wings in Kashmir?

In reality, it was most likely a combination of multiple factors, many too small for us to even notice.

Well, every movement in the stock market is like that leaf, but infinitely more complex. However, here we have a story for every leaf falling.

Think about a financial news headline you read recently. “Nifty 50, Sensex at All-Time High: What to Expect from Indian Stock Market on September 25” or “Market Plunges Amid Russia-Ukraine Tensions!”

Sound familiar? These attention-grabbing headlines give us neat explanations for the complex movements of the market. And we do believe them.

We believe them because doing so gives us comfort. Comfort from thinking that we understand why things happen in finance and investing. Comfort from believing that we are in control and can predict the future.

We are born storytellers. Stories captivate us. Our innate tendency is to seek meaning, draw patterns, and make sense of the confusion around us. It is a good quality of being human. However, the same instinct that makes us good storytellers may also deceive us when it comes to investing.

Nassim Taleb calls it a “narrative fallacy” in his book ‘Black Swan.’

He explains that while these stories often seem to make sense in hindsight, they are usually simplistic and fall short of conveying the actual complexity of the financial markets. More importantly, they frequently downplay the significance of luck and chance.

Many events that occur in the stock market – including the daily stock price movements – result from multiple factors, many of which cannot be easily predicted or explained. If we create stories around them, we risk overestimating our ability to understand the past and predict the future.

Taleb wrote in his book –

The narrative fallacy addresses our limited ability to look at sequences of facts without weaving an explanation into them, or equivalently, forcing a logical link, an arrow of relationship, upon them. Explanations bind facts together. They make them all the more readily remembered; they help them make more sense. Where this propensity can go wrong is when it increases our impression of understanding. [. . .] We like stories, we like to summarize, and we like to simplify, i.e., to reduce the dimension of matters. [. . .] The fallacy is associated with our vulnerability to overinterpretation and our predilection for compact stories over raw truths.

Daniel Kahneman wrote in ‘Thinking, Fast and Slow’ –

Flawed stories of the past shape our views of the world and our expectations for the future. Narrative fallacies arise inevitably from our continuous attempt to make sense of the world. The explanatory stories that people find compelling are simple; are concrete rather than abstract; assign a larger role to talent, stupidity, and intentions than to luck; and focus on a few striking events that happened rather than on the countless events that failed to happen. Any recent salient event is a candidate to become the kernel of a causal narrative.

The Sketchbook of Wisdom: A Hand-Crafted Manual on the Pursuit of Wealth and Good Life

This is a masterpiece.
Morgan Housel, Author, The Psychology of Money

The Danger of Believing Our Own Stories

Once we believe we understand why something happened, we are more likely to assume that we can predict what will happen next. If we think a stock rose because of a company’s innovative product, we might feel confident that its price will continue to increase as the company expands.

However, markets are notoriously unpredictable, so even a seemingly apparent cause-and-effect link could be a mirage.

Many investors are shocked by unexpected outcomes because they base their decisions on stories that are too simple, having been lulled into a false sense of security by their knowledge of past events.

Confirmation bias, or our tendency to ignore evidence that contradicts our preconceived notions in favour of information that confirms them, is also strongly connected to the narrative fallacy.

When you buy a stock, and it falls after that, your first reaction is to tell yourself, “That’s just a temporary fall! I know the stock is very good and will do well over time.” This reasoning is acceptable if you are holding on to a fundamentally sound business. But if you realise that you have made a mistake buying that business and don’t want to sell out at a loss, you look out for reasons validating your thoughts.

You look for reasons that confirm your decision that the stock is good. You check out websites and message boards, spend time on business channels, or call your broker to get his view. And even before you are about to get that second opinion, you expect it will confirm your beliefs. If that isn’t the case, you look to another person’s views that will validate your decision. In effect, this cycle repeats till the time you lose hope. And then you finally sell the stock at a huge loss!

Another example. If you believe that green energy or defence stocks will continue to rise due to greater demand in the sectors, you might disregard warning signs about overvaluation or broader market trends that suggest a downturn. This selective memory can distort your investment process and increase your exposure to risk.

Anyways, perhaps the most dangerous aspect of the narrative fallacy is that it blinds us to the role of randomness in financial markets. We frequently overlook the extent to which historical events were influenced by chance when we construct flawlessly plausible explanations for them.

Taleb warns that even the most successful investors may have been lucky in the past, but their successes get attributed to skill in the stories we tell ourselves.

This excessive reliance on narratives can lead to disastrous results when luck eventually runs out.

How to Break Free from the Narrative Trap

It is difficult. Why? Because as I mentioned earlier, we are natural tellers and believers of stories.

However, recognising the narrative fallacy and its dangers is a good first step toward avoiding it.

One way to do that is to appreciate and accept that there is something called as ‘uncertainty’ – that we do not know most of how the world and markets will move in the future.

It is thus essential to acknowledge the role of randomness and avoid placing too much faith in any one explanation for market movements. When we accept that we cannot always know what will happen next, we can approach investing with more humility and caution.

Diversification is another defence against the unpredictability of the markets. You can lessen your exposure to any one event or story by spreading your investments across various assets and businesses. This reduces the danger of placing an excessive amount of money on a single explanation or story.

Not to forget the importance we must put on the process than the outcome. Rather than focusing on whether a particular investment was successful, we should focus on whether our decision-making process was sound.

Did we base our investment on sound research and long-term strategy, or were we swayed by a compelling story?

It’s about playing the long game, not winning every hand.

Letting go of simple narratives doesn’t make the world of investing less interesting. If anything, it becomes more fascinating.

You start to appreciate that markets are like a complex adaptive system and are moved by countless factors than the ‘one’ you hear on business media. You develop a healthy respect for the role of chance. And paradoxically, by accepting that you can’t predict everything, you become a wiser, more resilient investor.

The goal of knowing about narrative fallacy is not to stop enjoying stories. It’s to recognize them for what they are – simplified versions of a complex reality.

In investing, as in life, the truth is often messier, more nuanced, and far more interesting than any single story can capture. And the best investors are not the ones who can tell the most compelling stories, but those who can walk through the unpredictability and volatility of the market with patience, intelligence, and a good dose of scepticism.

And that, my friend, is a story worth striving for.

That’s all from me for today.

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Thank you for your time and attention.

~ Vishal