For the next great investment story

We are wired for stories

The human brain is an awe-inspiring feat of evolution. According to biologists, it has approximately 90 billion nerve cells which are linked together by, literally, trillions of connections called synapses. Taken together, this system of elaborate connections within the brain provides “hundreds of trillions of different pathways that brain signals travel through. Our internal and external senses transmit almost four hundred billions bits of information per second through these pathways.

“In an effort to mimic this digitally, scientists a few years ago needed more than 82,000 processors running on one of the world’s fastest supercomputers to mimic just 1 second of a normal human’s brain activity.” – bgr.com

All this, while consuming a fraction of the power needed by a standard 60 Watt filament bulb. A supercomputer needs approximately 10 Million Watts.

The brain’s ability to make sense of the information deluge comes from two things:

  • to quickly discard information not relevant to the task at hand, also called “inattentional blindness” – remember the video on a basketball court asking you to count the number of passes between players of one team? link to the video
  • to put things neatly in order with cause-and-effect relationships to make sense of the world around us.

Narrative Fallacy – A story for everything

This second ability is to “order” things in neat relationships is a powerful tool to extract simple-to-store meanings from large amounts of information.

Consider this ad for Google Search using love in Paris:

Compare the fuzzy feeling you felt after watching the ad to one with a voiceover talking of individual features of google search. We’re wired to respond better to stories. But it’s this affinity for stories, where none might exist, that’s a common cognitive bias, Narrative Fallacy.

In the 2009 movie ‘The Informant’, a true story of Mark Whitacre (played by Matt Damon), is an upcoming senior executive at ADM, where he blows the whistle on large-scale price-fixing of lysine. Working with the FBI over three years, he gathers hundreds of hours of audio and video footage as evidence. Subsequent investigation surfaces that Mark had embezzled over $9 Million from ADM while working with the FBI and that he had a bipolar disorder that led him to lie, a lot. One of the things he makes up is his backstory that “his parents were killed in a car accident when he was young and was adopted by a wealthy man in Ohio who owned amusement parks”. His rationale was, people have favourable feelings towards those who’d been adopted and this helped him at various points in his life, from being accepted in college to doing well in job interviews.

We form opinions and assign causes based on back-stories all the time.

“Akhilesh drives himself hard in his Investment Banking job because of the hunger from his humble middle-class upbringing”

“Isha’s grandfather was an acclaimed Urdu poet, which explains why she’s such a good copywriter”

“The Managing Partner of x professional services firm booked himself on a flight next to the CEO of y and managed to get their business a few months later”

How this bias sabotages investors

  • The bounce in share prices explained in poorly designed financial media as being from poor jobs data that will not allow the Fed to raise rates thus driving the rally in equity markets
  • The celebrity super-investor who went from managing ₹1,000 to ₹50,000 Crores by identifying multi-baggers by visiting the company warehouses to see the amount of stock moving in and out
  • The ‘Electric Vehicle Megatrend” that will see the demise of the internal combustion engine and fuel prices of manufacturers of lithium-ion batteries to graphite rods

Buying into the premise that the effect followed a specific cause, and making decisions around cloning “super” investors, choosing money managers and hopping on to investment themes are the pitfalls for investors susceptible to this bias.

Dealing with Narrative Fallacy

The real issue with stories: they give us a false sense of understanding, which inevitably leads us to take bigger risks and urges us to take a stroll on thin ice. Whenever you hear a story, ask yourself: who is the sender, what are his intentions, and what did he hide under the rug? The omitted elements might not be of relevance. But then again, they might be more relevant than the elements featured in the story. – From ‘The Art of Thinking Clearly’

The point is not that all stories are false, but being aware that our minds are attuned to create stories where none might exist. If someone appeared on CNBC talking about how he made a fortune investing in companies with names beginning with the letter ‘W’, you’d laugh it off. But when someone appears speaking of having identified companies by speaking to a few dealers, customers and ex-employees, we take the process as the gold-standard of fundamental analysis and listen to their stocks tips without necessarily considering their incentives in offering them.

Be sceptical of simple explanations to extraordinary results. Recognize the prevalence of survivorship bias in understanding keys to success.

Further Reading:

The Narrative Fallacy and what you can do about it – farnamstreet.com

Computers versus Brains – scientificamerican.com

How powerful is the human brain compared to a computer – bgr.com

The Calm Investor | Narrative Fallacy
Source: scientificamerican.com

One thought on “For the next great investment story

  • October 29, 2017 at 10:40 am
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    Nicely written , mate:)

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