narrative+fallacy

An article of a fallacy which was popularised by Nassim Taleb in his book 'The Black Swan'. It describes how we readily create and subscribe to stories to explain complex events. BY NICK ARMET

//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.” // //—Nassim Nicholas Taleb, The Black Swan //

Narrative fallacy is a concept that was popularised by Nassim Taleb in his book ‘The Black Swan’. It describes how we readily create and subscribe to stories to explain complex events. The problem is these stories tend to be simplifications which force causality onto events in a way that colours our view of the past and the future.

In a complex world, our brains unconsciously search for patterns in order to store information in shorthand. This allows us to operate with a small working memory and avoid sensory overload. It's easier to interpret a group of complex events as a story than to remember each separately. This process of simplifying, clustering and chaining ideas and events together helps to reduce complexity to some memorable factors. It is why in childhood, we learn the alphabet by song and remember the colours of rainbow by rhyme.

Our natural tendency to establish patterns in information is not in itself a problem; knowledge and learning is about drawing connections and making inferences. And in evolutionary terms, it was beneficial since patterns indicating danger or safety are prevalent in nature. The problem arises when our brains do this automatically, finding links and patterns whether they exist or not.

The difficulty for investors lies in finding patterns where there are none, or buying into a compelling investment ‘story’ without doing the research. In fact, narrative fallacy is a pernicious bias in behavioural finance that is instrumental in causing other biases such as hindsight bias, confirmation bias and the halo effect.

The key reason our tendency to turn everything we see into a story is problematic is because it imposes a beginning, a middle and an end onto events. This implied causality makes past experiences seem as if they had a linear chain of cause and effect. But as Taleb is at pains to point out, the real world isn't like this - events are complex, sometimes interrelated, sometimes not, direct causation is actually quite rare and outcomes are of a probabilistic nature, based on a range of scenarios.

The problem is that as soon as an outcome has happened, we interpret it as if it was pre-ordained and “A” inevitably led to “B”. At the time of the financial crisis, uncertainty and fear was rife; it was difficult to know what was going to happen next. Now, it’s easy to fall into the trap of imposing an overly simplistic story onto those past events, believing for example that Lehman Brothers was always somehow doomed to bankruptcy.

By reducing complex events into a simplifying, sequential narrative, we impose a certainty and causality that might not have existed and we also tend to ignore the role played by chance. This causation problem is an example of a logical fallacy, known as the ‘**post hoc ergo propter hoc**’ assumption, which is Latin for ‘after this, therefore because of this’. While some level of causality may or may not have existed, the problem is that simplifying narratives grant us the excuse of not fully under¬standing what really went on.

//It's hard to avoid this simplifying interpretation – since it operates on a sub-conscious level. It takes a conscious act will to // //move beyond it; we have to engage the rational, calculating part of our brains to build understanding by testing our beliefs. // //One of the key problems with narrative fallacy is that it also colours our view of the future by making us think that events are more predictable than they actually are. So, the same condition that makes us simplify things also fools into us to thinking that the world is more predictable and less random than it is. This causes us to underestimate the likelihood of what Taleb calls ‘Black Swan’ events because they lie outside of our regular expectations. Only once they happen are they subject to an explanatory story that makes them appear predictable. //

An example of narrative fallacy within investment is the idea that economic growth always leads to stock market growth. This powerful narrative helped to drive widespread interest in emerging markets over the last decade. While there is an intuitive link between economic and stock market growth over the longer term, the relationship is unreliable and unproven in the short term. This was borne out in the stock market returns of major geographies in 2012 – despite having some of the poorest rates of economic growth on offer globally, European stock markets were among the best performers. Meanwhile, China has underperformed over the last three years despite the fact its economy still offers relatively attractive rates of growth (albeit having slowed from peak rates). The chart shows that European equity returns have outran economic growth over the last 20 years and have diverged by large margins in the past. Reinvested dividends, valuation, and changes in earnings per share (EPS) are all crucial in determining equity returns and many globally diversified European companies have been very successful in growing their earnings despite the regional economic malaise. In investment, there has always been a danger of investors being tempted by a persuasive story without doing the fundamental research into industries and stocks. The dot.com boom at the turn of the millennium – when ‘click rates’ became one indication of a company’s value - was another good example of ‘the story’ running much too far ahead of the fundamentals

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