Narrative Fallacy

Narrative fallacy is an individual’s inclination to construct an explanation or create a logical story for any occurrence or event, even if the proof does not support the explanation.  In finance, it can lead to people making incorrect decisions. Resultantly, they might damage their reputation or incur losses.

This tendency addresses one’s limited ability to observe a series of facts without forcing a rational link upon them or constructing a coherent explanation. This phenomenon results in a distorted or partial view, as individuals may end up interpreting occurrences in a manner that is in line with their preconceived notions. 

The narrative fallacy definition refers to a phenomenon that involves individuals drawn towards a certain outcome that is less desirable solely because it is associated with a better story. In financial markets, having preconceived beliefs can be detrimental if the narrative does not reflect reality. Psychological factors drive this type of behavior. Hence, overcoming it can be challenging for individuals. 

The issue is that human beings typically develop the habit of utilizing narratives right from childhood. The inclination to look for stories continues even when they become investors and make any decision in the market. For example, suppose four or five facts are available regarding a stock. It is a general tendency among humans to try and connect these facts to establish a cause-and-effect relationship. 

For instance, if news comes out that the price of ABC stock has decreased significantly and two promoters of a business are offloading a large number of their shares, people tend to connect the two pieces of information and construct a story. Here, the likely inference would be that those two promoters are offloading their stake as the share price of the company is decreasing. In many cases, the narrative might turn out to be correct. 

That said, in other cases, it might not reflect the truth. For instance, the promoters might be selling their shares so that more funds can be acquired to fulfill the company’s growth goals. Also, the price of a company might fall because of a number of reasons, including political shocks or a change in the interest rates. 

In the world of finance, this phenomenon can result in wrong decisions when investors fail to proceed with caution regarding stories sold to them. For example, an intermediary may try to portray facts in such a manner that weaves implicit assumptions into them. Later on, the investors may find out that such assumptions were wrong. By that time, it might be too late to avoid the financial losses. 

Let us take the example of those investment bankers who sold the story of the high growth potential of real estate in the US. Moreover, the assets followed a tranche model, which meant people purchasing high-rated financial instruments would get protection from prepayments and defaults. 

That said, the bankers did not say anything about the implied assumption that the real estate prices will continue increasing in the future. They left it to the investors, who inevitably fell for that assumption as they observed the recent market trend. The implied assumption was incorrect. As a result, they incurred substantial losses when the real estate market crashed. 

In business or investment, individuals can identify this phenomenon by looking at the following factors: 

• Historical Returns: Rather than depending on any external source for data, individuals could look at companies’ official disclosures. It is mandatory for mutual funds and insurance companies to reveal the net asset value or NAV of funds and the returns periodically. They can refer to the disclosures and avoid making decisions based on stories created out of implicit assumptions. 
• Company History: During geopolitical scenarios, for example, the war between Ukraine and Russia, one’s narrative fallacy would push them towards shares of defense companies or mutual fund funds with exposure to defensive stocks. That said, it is crucial to keep in mind that not every defense company stands to benefit from this type of conflict. Hence, individuals can allocate funds to an organization by considering past defense deals, revenue, profitability, history, and estimates concerning future growth.

Let us look at a few narrative fallacy examples to understand the concept better.

Example #1 

Suppose Jim is a novice trader who opened a new trading account with ABC Broker. Per the advice of the brokerage firm, he invested funds worth $20,000 in Company DFG. The shares of the automobile manufacturing company skyrocketed over 30% in 2 days. 

The narrative was that since the organization plans on launching 10 diesel cars with manual transmission in 6 months, its profits would rise significantly. Jim believed in the broker’s narrative, ignoring multiple key aspects, for example, the growing preference towards electric vehicles with automatic transmission and the increasing competition in the automotive space. Moreover, he also did not factor in the news that the government might change the emission norms, which would be unfavorable for diesel cars.

He only took into account the price surge and the positive news on different media platforms. Following his investment, the government announced changes in the emission norms, and the stock plummeted. As a result, the narrative fallacy led to him suffering significant losses.  

Example #2 

In 2014-2015, the stock market in China went on a bull run. The rally was phenomenal, as the market kept recording new highs. That said, there were no sound fundamentals for the basis of this surge. It was state propaganda that drove the price upwards. The media in the country constructed elaborate narratives suggesting a growth spurt within the economy. There were stories indicating that some companies would potentially transform industries, and individuals bought into the narrative. 

As the government relaxed margin trading norms, people would bet an unimaginable amount of money unable to avoid the narrative fallacy. Soon, the Chinese government took measures to control margin lending, which resulted in people fearing the worst. Out of panic, they sold the shares at throwaway prices, realizing that the rally would eventually cease to exist. As a result, the markets tumbled, and soon, an inevitable crash followed. 

A tendency to believe in a story restricts individuals’ ability to assess the information available to them objectively. Hence, it leads to them making incorrect decisions. This is a key reason why individuals often steer clear of value investing. After all, this investment approach forces people to consider stocks not having a great story. In fact, some of the stocks are often associated with horrendous stories. The equities admired the most tend to have the best stories. However, they come with a high price too. 

For many years, stock brokers have utilized this phenomenon to their advantage by convincing investors to allocate funds to a stock of a company by selling an exciting story regarding the organization. 

There is only one way to steer clear of this phenomenon. It involves questioning all the underlying assumptions made at the time of making any investment. It is quite natural that investors consider alternative investment options in the form of a story. That said, it is key to remember that some assumptions and facts form the basis of the story. Prudent investors must be able to distinguish the facts from the assumptions and question the latter’s validity prior to making a decision.