Stop Looking for “the Story” Why Markets Are Falling

Whenever we see any sort of disruption in markets an explanation usually follows. The headlines will explain that “Markets are going up/down because of this good/bad thing.” News anchors will solemnly intone why the volatility is significant and what it means for one thing or another.

None of these casual explanations can withstand close examination. They are often things that have existed for months or years, and so can’t account for what happened yesterday.

Stocks are fully valued, and have been for a while, so why is it that valuations suddenly matter after not mattering at all? The market for initial public offerings is too hot? Wait, the Federal Reserve is going to end quantitative easing, something it has been warning us about for two years? Now it suddenly matters?

Of course, all of these narratives serve a singular purpose: They give the appearance of meaning and rationality to actions that are meaningless and irrational. The daily action in the markets is a form of noisy, random, Brownian motion. If you are looking for a clear reason as to why stocks did what they did, then you are in the wrong line of business.

Given that truth, it was with great pleasure this morning I read a headline in the Wall Street Journal that accidentally reflected this reality: “Biotech Stocks’ Rout Perplexes Analysts.”

There are several things that make this such a wonderfully inadvertent truth-telling exercise. The headline implies that other times when stocks get shellacked, the analysts know and understand the reasons why. Never mind that they cannot forecast where these stocks will go, and all of their explanations are a post-hoc rationalization. But this time they are perplexed.

I find that delightful.

Here is the simple reality most of us try desperately to ignore: Most of the time, we have no idea what is going on. Our understanding of objective reality is at best tenuous. At its worst, our beliefs reflect a completely erroneous viewpoint, one that is as comforting as it is misleading. Indeed, the comfort often comes from hiding the truth from ourselves.

Consider this explanation of the artificial construct most of us live in: People create a happy little bubble of delusion. We engage in all sorts of cognitive foibles. Our selective perception allows us to only see that which agrees with our preconceived notions. Our selective retention only holds onto the stuff that confirms our views, disregarding the rest. In our minds’ eye, we are younger, better-looking, slimmer, and have more hair than an objective observer would see. The universe we construct bears only a passing resemblance to the objective world.

Sometimes, Toto pulls back the curtain and we see the wizard is nothing more than an old man with a few parlor tricks. For a brief moment, we understand how little we really understand. The grim reality of human cognition is that however little we know, we understand even less.

Hence, the accidental revelation in the headline is more noteworthy for how extraordinary it is.

Markets move up and down for no apparent reason. We have spilled plenty of ink and generated billions of pixels explaining why people want and need reasons to explain these movements. The human love of narrative is a dangerous cognitive failing that constantly leads investors astray.

As the ghost of famed trader @Jesse_Livermore tweeted, “People say the mkt will invent a reason as it falls — well, it hasn’t managed to invent one yet, despite extremely jittery price action…”

You can fabricate a story that makes you feel good. Or, you can face reality. Too many investors opt for comfort over truth. You can see it in their performance.


Originally published here


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