Narrative Rules

Stock Market Stories Lead Us Astray
Trying to explain why financial markets behave in a certain way often comes down to a narrative that makes sense, even if it’s not accurate.
Bloomberg, February 13, 2014

After a string of up days, most markets were showing red earlier today. We never know what the daily action of the markets will look like in advance. Whether you want to call it a random walk or the madness of crowds, those of us who toil in the capital markets can rely on no two days being the same.

However, one thing that occurs regardless of circumstances, data or specific events: The endless attempts made to explain the day-to-day in a narrative format. This futile gesture seems to occur regardless of the overall circumstances. Investors want an explanation that gives them comfort, even if their portfolio fails to do so.

Hence, our love affair with the “if-that” news dynamic. IF this occurred, then THAT was the natural reaction in the markets. One of the few guarantees that can be made in investing is that you will be subject to an endless stream of this sort of explanation.

What were this morning’s excuses for why markets were soft today? Pick your poison:

• U.S. retail sales “unexpectedly” fell 0.4 percent because of inclement weather in January;

• Weak earnings from companies as varied as BNP Paribas to Cisco Systems undercut the expansion story;

• Some currency issue somewhere — today it was the Swiss franc that was rallying! — therefore something else is doing poorly;

• Europe’s six-day winning streak was due to end eventually.

We can debate the merits of any of the above data points, but the simple reality is that there is only so much valuable information to be derived from observing the news flow. When we consider the day-to-day action of markets, we see it is mostly random noise, very little of which makes much difference over the long haul.

Indeed, the longer your timeline, the more even significant events look like just little squiggles. Consider such world-shaking events as the JFK assassination, the 1987 stock-market crash, or the 9/11 terrorist attacks. On a long-term chart of the Standard & Poor’s 500 Index, they are reduced to static. Over the long haul of history, even monthly action starts to look like not very meaningful noise.

Why is that? I place some of the blame on that very if-that format, which came about as a function of our love of narratives. The narrative is the preferred way to share information across just about every human culture.

Sure, it is very often misleading, but it works for most typical forms of information transfer. It is incumbent upon us to recognize how often this format creates context or analogs that are simply false. Credit the field of behavioral finance for identifying just how misleading — and costly — the narrative format can be.

I want to address this issue in much greater detail in the near future, but suffice it to say that the desire for an easy to follow and memorable narrative typically trumps accuracy and precision almost every time.

Why were the future down this morning, and why has the market recovered since then? To answer that, I have to tell you a story.

Originally: Stock Market Stories Lead Us Astray