Once Again, The Narrative Fails

Late last year, we had a wholesaler from a major ETF firm in our office. At the time, the chatter was all about the upcoming Alibaba IPO. It was going to be (in his words) “huge, disruptive, incredibly powerful – and you cannot get any.”

Never mind that IPO returns are on average mediocre or worse, or that chasing hot syndicate deals is not in our wheelhouse. This guy had a great story to tell, and to the uninitiated, it was enrapturing.

“This is going to be the hottest Tech IPO of the year, bigger than Twitter, bigger than Facebook. Only firms on mainland China are going to have access to it. (Not you). The way to play it is to own all of similar companies in China that are in the Technology and Internet space.”

The story, as it turns out, was completely and utterly wrong. No, thius is not listing in China. Alibaba Group Holding Ltd. is listing on the NYSE, and anyone who wants to can buy its stock. Whether you should is an entirely different matter, but not the subject of this column.

The narrative, as is so often the case, failed. But not its appeal to our deep lizard brains. Longtime readers know this is afavorite issue of mine. For almost all of human history, the written word didn’t exist. We developedstory-telling to share information among people, and pass on through the generations: When certain animals were around for the hunt; what poisonous mushrooms not to eat; the changing seasons, weather and more.

To our ancestors, a well-told and compelling narrative was much more than mere entertainment. It was a matter of life or death. Your brain has evolved not to make capital markets decisions, but to survive on the savannah. That our own wetware, rife with cognitive shortcomings and easily fooled, allow narrative to so often mislead us becomes a problem when it comes to investing. Humans just aren’t built for it.

My favorite example of this comes from the 2012 election. Peggy Noonan, a pundit and former speechwriter for President Ronald Reagan, was forecasting a victory for Republican presidential candidate Mitt Romney based on anecdotal evidence of lawn-sign numbers and what she called “vibrations.” As I observedpost-election:

“My favorite example (of failed narratives) was the yard signs in Florida reflecting an advantage for Romney in enthusiasm amongst his political base. There are very obvious modeling issues with that: What was the method for measuring those signs? How widespread was this nationally, and more importantly, in swing states? What is the past correlation between numerical signage advantages and election outcomes, etc?

Noonan’s confirmation bias led her to believe that the overwhelming majority of people were supporting her candidate. She constructed a compelling narrative based on her biased observations. Selective perception allowed her to ignore other data, e.g., people in urban areas don’t have lawns, and therefore don’t have lawn signs. Her cognitive dissonance explained away other polling data (“polls are all biased”).

Despite the prevalence of Romney lawn signs in tonier parts of south Florida, he lost the election by 5 million votes and was thumped in the electoral college, 332 to 206. So much for that narrative.

In politics, when your narrative fails, the other guy wins. With investing, following narratives leads to lost capital.

What sorts of stories do investors tell themselves? Narrative is used to sell a product; the pitch often includes some combination of the following:

— new management team

— hot new products

— faster growth

— strategic acquisitions

— new market penetration (China!)

— value proposition

— earnings outlook

— takeover target

— Food and Drug Administration approval

And on and on.

The narrative makes for a compelling story. It appeals to us emotionally. It often falls apart when scrutinized. What is this analyst’s track record of predicting FDA approvals? Can anyone really evaluate a management team’s impact on stock prices in advance? How many of you anticipated the success of the iPod, iPhone or iPad — enough to risk capital on it? Experience teaches us that the track record of these inputs is found wanting.

Narratives typically focus on squishier, less quantifiable aspects of an issue. They hit emotional buttons, making the reader feel good about the story. That makes selling a perspective or a product that much easier.

Alibaba is going public in the U.S., not in China or Hong Kong. It’s going to be listed on the NYSE. What narrative can you construct around that? Other people are already hard at work on it.

Originally: The Alibaba Story-Telling Failure