When confronting new challenges, it’s all too easy to impose an overly simplistic narrative solution based on past experience, as Nick Armet writes.
Narrative fallacy is a concept that was popularised by Nassim Taleb in his book The Black Swan.
It describes how we readily create and subscribe to stories to explain complex events. The problem is these stories tend to be simplifications which force causality onto events in a way that colours our view of the past and the future.
“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 easily remembered; they help them make more sense. Where this propensity can go wrong is when it increases our impression of understanding.” – Nassim Nicholas Taleb, The Black Swan.
In a complex world, our brains unconsciously search for patterns in order to store information in shorthand. This allows us to operate with a small working memory and avoid sensory overload.
It’s easier to interpret a group of complex events as a story than to remember each separately. This process of simplifying, clustering and chaining ideas and events together helps to reduce complexity to some memorable factors.
It is why in childhood, we learn the alphabet by song and remember the colours of rainbow by rhyme.
The difficulty for investors lies in finding patterns where there are none, or buying into a compelling investment ‘story’ without doing the research.
The key reason our tendency to turn everything we see into a story is problematic is because it imposes a beginning, a middle and an end onto events. This implied causality makes past experiences seem as if they had a linear chain of cause and effect.
But as Taleb is at pains to point out, the real world isn’t like this – events are complex, sometimes interrelated, sometimes not. Direct causation is actually quite rare and outcomes are of a probabilistic nature, based on a range of scenarios.
The problem is that as soon as an outcome has happened, we interpret it as if it was pre-ordained and “A” inevitably led to “B”. At the time of the financial crisis, uncertainty and fear was rife; it was difficult to know what was going to happen next.
Now, it’s easy to fall into the trap of imposing an overly simplistic story onto those past events, believing Lehman Brothers was somehow doomed to bankruptcy.
One of the key problems with narrative fallacy is that it also colours our view of the future by making us think that events are more predictable than they actually are.
So, the same condition that makes us simplify things also fools into us to thinking that the world is more predictable and less random than it is.
This causes us to underestimate the likelihood of what Taleb calls ‘Black Swan’ events because they lie outside of our regular expectations.
Only once they happen are they subject to an explanatory story that makes them appear predictable.
An example of narrative fallacy within investment is the idea that economic growth always leads to stock market growth. This powerful narrative helped to drive widespread interest in emerging markets over the last decade.
While there is an intuitive link between economic and stock market growth over the longer term, the relationship is unreliable and unproven in the short term.
This was borne out in the stock market returns of major geographies in 2012 – despite having some of the poorest rates of economic growth on offer globally, European stock markets were among the best performers.
Meanwhile, China has underperformed over the last three years despite the fact its economy still offers relatively attractive rates of growth (albeit having slowed from peak rates).
Chart 1 shows that European equity returns have outran economic growth over the last 20 years and have diverged by large margins in the past.
So can investors avoid falling into the trap of narrative fallacy? The answer is a qualified yes. It takes conscious, deliberate, and continuous effort, since insight is hard earned.
By undertaking painstaking research and turning over plenty of rocks, we can escape simplified interpretations and build a more insightful picture of an investment opportunity.
We can undertake due diligence, make conjectures, test and corroborate ideas, run models, and make informed yet verifiable predictions.
By favouring empirical research over rudimentary stories and by being initially sceptical about the data we collect, the patterns we detect, the interpretations we make and the conclusions we draw, we can incrementally strengthen our understanding. By embracing the opposite view we can test our assumptions.
And, by using probability-based scenario analysis, we can form better strategies that are not dependent on binary outcomes. Indeed, there’s one old story that is always worth remembering: there’s no such thing as a free lunch in investing.
Nick Armet is an investment commentator at Fidelity Worldwide Investment.
