Are You A Victim Of Overly Simple Narratives?
Humans have an innate need for explanations. In our minds, every effect must have a cause, and we naturally seek out reasons for events that occur.
This is part of a broader narrative bias, and while useful in simple scenarios, it can be dangerous when applied to complex systems like financial markets.
14. Narrative Bias
This danger stems from us falling for false narratives, that is, narratives that are constructed out of the need to “scratch the itch” of our need for an explanation.
Just think of the last time you came across a headline that followed this simple formula: Market goes up/down because [some reason].
For example, “Market goes down on fears of Fed hike”, or “Market goes up on the back of stronger economic data”.
The financial media produces dozens of such headlines on a daily, and sometimes intraday basis, always attributing market movements to a single, simple, cause. Unfortunately, reality is a lot more complex, and most of the time, we simply cannot say what caused the market to move up or down.
For example, the headline “Market goes down on fears of Fed hike” implicitly assumes that the Fed raising interest rates is a negative for markets, when in truth, this isn’t always true. The logic applied by whoever wrote the headline runs along the conventional line of thinking that higher rates increase the cost of funding and hence lowers economic growth and equity valuations.
However, we know from the interest rate fallacy that this simply isn’t the case, and that higher rates are actually a byproduct of higher growth and increased business confidence, which, if anything, are indicative of higher stock prices.
Consequently, the narrative espoused by the headline is false, and people who read the headline (and possibly the article) will be led to mistakenly equate rate hikes with lower equity prices!
Moreover, daily trading volume for US equities is in the hundreds of billions, which makes it quite unlikely that stocks will move higher or lower because of one simple factor (the obvious exception to this is a financial crisis, where everything is falling because of fear based selling).
After all, the stock market has myriad participants, each with their own reasons for buying or selling. Which means that the only statement that can be made with accuracy is: Stocks are higher because more people are buying than selling, and vice versa.
Unfortunately, the explanation provided by this statement fails to capture the imagination (some might not even consider it an explanation), which would explain why it is never used.
Furthermore, financial markets are complex systems, and while its short term movements can be random or influenced by events, there is often a lot more going on. Since headlines tend to focus on short term market movements and events, it isn’t surprising that they conflate both into a cause and effect relationship.
However, in doing so, they ignore information which is much more important like the context behind the price move. This context is more often than not the market’s longer term trend; and if stocks are trending lower, it is quite likely that prices on any given day will fall, regardless of a Fed hike.
Therefore, when we succumb to our narrative bias we not only fall for false narratives, we also fall into the trap of reductive thinking, both of which can lead us to trade on information that is incomplete and/or inaccurate.
Beware your narrative bias!
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