Blogs | June 3, 2013

Can storytelling be harmful to investments?

Everybody loves a good story. When it comes to investing, however, this love can be positively dangerous.


I was reminded of this a few days ago when on 23 May 2013 the FTSE 100, along with many major share markets, fell by more than two per cent. “Markets fall sharply on Fed quantitative easing fears,” the news reports said.

This, though, made little sense. As Federal Reserve chairman Ben Bernanke made clear – well, as clear as central bankers get – the Fed will only cut back its QE when the economy is strong enough, and a strong economy should be good for share prices. This in turn means the withdrawal of QE is ambiguous for shares. We should be as likely to read the headline “Market falls on fears of reduced QE” as “Market rises on signs of stronger economy”. They’re just two sides of the same thing.

Beware “narrative fallacy”
Why, then, should we attribute a fall in shares to the (perhaps distant) prospect of QE ending? It’s because of our love of stories. We need to believe there are patterns in human behaviour, and clear reasons for complex events; a fall in share prices, remember, is the result of tens of thousands of individual decisions, some of which are made for all sorts of abstruse motives.

Primitive man would see patterns in fire, and ascribe their good or bad luck to the will of the gods. We haven’t much progressed. Instead, we commit what Nassim Nicholas Taleb, author of The Black Swan, calls the “narrative fallacy”. We over-interpret events and tell simple stories to explain complex or random behaviour. Nobody is satisfied with the statement “It’s just one of those things” – least of all journalists who have to fill space in newspapers.

Can we predict the markets?
This fallacy has real costs for investors. It encourages the belief that we can predict the market. If only we had a better understanding of the economy or of the Fed, maybe we could have anticipated that fall in the market.

But this is not true. Investors have tried for years to make money by moving in and out of equities at the right time, and, says research, generally failed. “Pension funds do not have active rebalancing skills” was the conclusion of one recent study of US funds. And a study of hedge funds found that only around one-fifth had some ability to time the market.

The narrative fallacy is closely related to the hindsight bias. With hindsight, things seem predictable. But in fact, they are not. English stockbrokers of a certain vintage used to describe sharp daily falls as “technical corrections".  This was largely meaningless – they rarely specified the precise technique – but it’s better to be meaningless than misleading.

Some things are just random (but do the maths)
So, what’s the alternative? Simple. We should recognise what western man has only really understood in the last 400 years – the blink of an eye in evolutionary terms – that some things are genuinely random and can be roughly quantified.

For ordinary investors, a useful rule of thumb is to expect stock markets in developed economies to give real annual returns of five per cent a year on average, with a standard deviation of 20 percentage points. Basic maths tells us that this implies that the standard deviation of daily returns is just over 1.2 percentage points.

This means there is a one in six chance of a market falling 1.2 per cent in a day. In other words, we should expect to see a fall of 80 points in the FTSE 100 or of 185 points in the Dow Jones roughly once every six days. And we should expect falls of more than 2.4 per cent roughly once every two months – though there’s no reason to suppose they will be so neatly spaced out.

Such movements don’t need explaining. They are just part of normal behaviour. We should learn to be satisfied with “it’s just one of those things”.

InvestingBias

Chris Dillow
Chris Dillow

Investors Chronicle writer and economist

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