In an ideal world, investors are supposed to look only at cold hard facts and analyze them while making an investment decision. However, till now, we know the fact that any of these decisions are not 100% rational. There is always an iota of emotions mixed in decision making, even for the most rational investors.

While conducting research, behavioral practitioners have found that investors base their decisions more on narratives than on the facts themselves. They have labeled this as the “narrative fallacy.” In this article, we will understand what the narrative fallacy is and how it impacts investor decision making.

What is Narrative Fallacy?

A narrative is defined as a story that is used to communicate certain details. In the investment world, a narrative is considered to be good if it resonates with the underlying beliefs of the investors. Simply put, a narrative is a way of communicating facts. This method relies on using emotions interspersed with facts during the communication process.

The problem is that we humans have been conditioned with using narratives right from our childhood. This tendency continues to exist when investors make investment decisions in the marketplace. For instance, if there are three or four facts available about a company in general, it is a human tendency to try to link these four facts and find a causal relationship between them. For instance, if we hear that the stock of a company has fallen down and then hear that the chairman of the company is selling stocks, we tend to link the facts together and form a story. In this case, the most likely conclusion would be that the company is failing, and hence the chairman is jumping ship.

In a lot of cases, this narrative thinking works in our favor. However, in some other cases, it is not very useful. For instance, it could be possible that the chairman is selling his/her shares in order to fund the growth of the company. Also, the fall in the price of stocks could just be because of external events such as interest rate changes, etc. In this case, the two facts are not related but instead random. Hence, binding them with an arrow of causality is a fallacy!

The tendency to forcefully bind together certain facts and create a story that may be untrue is the hallmark of the narrative fallacy. The narrative fallacy actually came into popular literature after the 2008 subprime mortgage fiasco. It was made popular by Nicholas Naseem Taleb, who mentioned it in his book called “Fooled by Randomness.” Ever since it has become an important subject of study in behavioral finance.

Why do Human Beings Follow Narrative?

Human beings find it difficult to keep track of random things. However, when things follow a logical sequence or are linked by cause and effect, then they can remember many facts. This is the reason that the tendency to build up stories. This tendency continues to present itself in the investment markets. Human beings are not comfortable with investing in stocks till they view the stocks as a set of numbers. However, when they hear the story behind the company and see the entrepreneurial spirit, they become much more comfortable with the investment. This is the reason that the narrative fallacy has been long used by brokers and middlemen to wrongly sell investments to unwitting investors.

How Narrative Fallacy Leads to Wrong Decisions?

The narrative fallacy can lead to wrong decisions if the investor is not careful about the story being sold to them. For instance, salespeople often use facts in such a manner that implicit assumptions get inbuilt into them. These assumptions could turn out to be wrong at a later stage and then impact the portfolio in a negative way. For instance, when investment bankers were selling mortgage-backed securities, they were actually selling the story of American real estate. They were explaining to investors that real estate has a high growth rate. Also, the securities followed a tranching model, investors buying high rated securities would be shielded from defaults and prepayments.

Now, what the bankers did not mention in this case, is the implicit assumption that the price of real estate will always continue to grow in the future. This was left up to the investors. The investors would invariably fall for this assumption since if they looked at the recent trend, they would only see real estate going upwards. This hidden assumption was flawed, and hence investors who bought this narrative suffered humungous losses when the real estate market turned negative.

Investors cannot really tolerate randomness in the market. Even if there is a small fall of 5% in the market, they try to look out for a reason. Well, in many cases, there is no reason at all! Prudent investors accept randomness. Other investors try to forcefully build a narrative using available facts.

How to Avoid the Narrative Fallacy?

The only way to avoid the narrative fallacy is to question the underlying assumptions being made while investing. It is natural for investors to consider investment alternatives in a story format. However, the story is based on some facts and some assumptions. Prudent investors try to separate the two and question the validity of the assumptions before they go on to make their decision.