In 2003, when Saddam Hussein was captured, Bloomberg News released the following headline: TREASURIES RISE; HUSSEIN CAPTURE MAY NOT CURB TERRORISM. About 30 minutes later, they released another: TREASURIES FALL; HUSSEIN CAPTURE BOOSTS ALLURE OF RISKY ASSETS.
This contradiction was made famous by Nassim Taleb in his book The Black Swan. Obviously, two opposite consequences can’t be explained by the same thing but that doesn’t stop a good story. As such, many similar paradoxical headlines are littered across the financial news landscape. In The Black Swan, Taleb argues:
The narrative fallacy addresses our limited ability to look at sequences of facts without weaving an explanation into them, or, equivalently, forcing a logical link, an arrow of relationship upon them. Explanations bind facts together. They make them all the more easily remembered; they help them make more sense. Where this propensity can go wrong is when it increases our impression of understanding
In the left hemisphere of our brains, there is a module called the interpreter whose job is to close cause and effect loops. If we act good, something good will happen. If treasuries rise, something must have caused them to rise. For the interpreter, luck and randomness are never the answer. This can cause problems.
The following is a TED talk given by Tyler Cowen on the subject of stories:
Cowen argues (through story) that stories are similar to candy – we can’t get enough of them. We are biologically programmed to respond to and remember a good story. For example, we all remember that George Washington cut down that cherry tree and couldn’t tell a lie. The fact that it probably never happened isn’t important.
Stories are everywhere. If you’re republican, you might tell the story of good conservative values versus evil liberal debauchery. If you’re democrat, you might tell the same story but reversed. Obviously both stories can’t be true, but that doesn’t stop people.
Conspiracy theories take this idea to the extreme. It’s a lot simpler to apply causation to a bunch of evil people plotting towards some nefarious goal, than it is to the complex unintended consequences of human action. The better the story, the more skeptical we should be.
Cowen closes his talk with the following thought:
To think in terms of stories is fundamentally human. We use memory and stories to make sense of what we’ve done, to give meaning to our lives, to establish connections with other people. None of this will go away, should go away, or can go away. But again, as an economist, I’m thinking about life on the margin. The extra decision. Should we think more in terms of stories or less in terms of stories. When we hear stories, should we be more suspicious? And what types of stories should we be suspicious of? It’s the stories very often that you like the most.
All of us have a natural understanding that the future is uncertain. Maybe the stock market will crash tomorrow. Maybe a war will break out somewhere in the world. Any number of possible things can happen tomorrow. But when we look back at yesterday, all we see is certainty. We see the events that happened and assume that they were the only events that could have happened. We just have to construct the most plausible explanation that fits. In hindsight, everything seems obvious.
An event could have been completely random and we will still find a reason for it. Once we have constructed that reason, we tend to ignore any evidence to the contrary. This tendency – to find patterns where none exist – is ingrained in our nature. If that swaying grass turned out to be a lion, and our ancestors didn’t run, it would have been game over. Today, we’ve expanded that mechanism of prediction with undue confidence. The roulette wheel landed on red 5 times in a row, black is guaranteed. The price of oil keeps dropping, it is due to go up. Pattern X will lead to outcome Y since it has in the past.
In reality, the uncertainty that exists forward also exists backward. More things can always happen than will.
As it relates to investing
Investing is about having an accurate view of the world. Thus, the best investors aren’t married to one way of thinking. Their favorite long position can be a short position at the drop of a hat. When the facts change, they change.
Being actively open-minded isn’t easy. We tend to fall in love with stories and simple explanations. To avoid this, it helps to have systematic way of updating our beliefs.
In his book Seeking Wisdom, Peter Bevelin explains how:
We refuse to accept the unknown. We don’t like unpredictability and meaninglessness. We therefor seek explanations for why things happen.
In an HBR interview, Michael Mauboussin put it this way:
When you see something occur in a complex adaptive system, your mind is going to create a narrative to explain what happened—even though cause and effect are not comprehensible in that kind of system. I think that’s the biggest single bias.
Stories and sensemaking allow us to function as humans – they get us up in the morning. However, when we underestimate the role chance plays in our lives, we are prone to overconfidence and flawed reasoning.