Human beings crave a narrative. Storytelling allows us to cooperate on different tasks by sharing beliefs about things like money, religion, and government. Think for a second about the money in your wallet. Why can you exchange that for a good or service? Because the business on the receiving end knows that it can use that money to pay employees or buy more inventory due to a shared belief in the currency’s value. As constructive as narratives are in certain areas, they can be potentially destructive when making decisions with one’s investments. This way of thinking leads us to deterministic conclusions about past, current, and future events that impair our ability to process information from an objective standpoint.
We’ve all heard that hindsight is 20/20. However, seeing the past with crystal clear vision could cloud our perception of reality more than help us understand how things are. For example, I often see an advertisement for a stock-picking service that promises an idea “like buying Amazon in 1997.” Fantastic, Amazon lost 95% of its value four years after 1997. We all know the behemoth that Amazon has grown into today but holding on in real-time as it transformed from an online book retailer to its current form would have required nerves of steel. What’s missing from any backward-looking analysis is the impact of chance. We potentially overestimate an event’s probability because that’s how it happened, and it makes the narrative of our current situation flow. Our stories will tell us that these companies were a sure thing, that they were destined to become great when, in fact, there was (and still is!) a lot of uncertainty. Avoid looking for the next big thing that is a sure bet because it does not exist.
Another common tendency is to take a current situation and extrapolate it into the future. Assigning greater importance to recent history is known as the recency bias. At the end of last year, it felt like the market would never go down again. At the end of June, it felt like it would never go up again. We all know that things will eventually change, but it’s easier for our brains to assume that the status quo will continue.
So far, we have seen the challenges that arise when we tell ourselves stories about the past and present. What happens when we add a variable like future events? If you are investing based on this type of “if/then” logic, you must be correct in your prediction of some future event, and you will also need to predict how the markets will react to said event. I hope you can see how difficult this is. For example, there is a tendency to assume that if a particular political party comes into power, that will be good/bad for the markets. It doesn’t matter on which side of the aisle you sit – history is littered with destructive decisions made by individuals based on this type of predictive analysis.
Alexander Hamilton said, “I have thought it my duty to exhibit things as they are, not as they ought to be.” So often, we paint our perspective of past, current, and future events with what ought to be that we miss what *is*. Keeping a level head and focusing on the long-term is a surefire way to improve your outcomes. Looking for blind spots in your narratives improves on that.
Author: David Rath, CMT, CFA
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