“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
As the 2014 Stanley Cup Playoffs reaches its conclusion with the Los Angeles Kings and the New York Rangers clashing in a best of seven series to determine the winner, I found myself falling for a narrative fallacy.
First some quick context; I am a lifelong New Jersey Devils fan and as such, it is practically my duty to root against the New York Rangers at every opportunity and particularly when they are on the cusp of achieving The Cup.
So it was toward the end of the Western Conference Finals with the Kings up three games to one against the Chicago Blackhawks, that I determined to root for the Kings based on the reasoning that the Blackhawks could only win if the series went seven games while the Kings could finish off the series in five or six games and as a result would be more rested and therefore more likely to defeat the Rangers in the Finals.
The narrative fallacy I fell for was that more rest at this point in the season would increase the likelihood of the Kings defeating the Rangers in the Finals. To my surprise, a recent Wall Street Journal article noted that in the last eight Stanley Cup Finals in which one team had three of more days extra rest compared to the other team, the more rested team lost seven times or 87.5% of the time. (Note: as of this writing, the less rested team, the Los Angeles Kings lead the New York Rangers two games to zero in their best of seven series.)
Falling for this narrative fallacy piqued my interest as the investment world is replete with narrative fallacies that are told and believed again and again despite clear evidence against them. Following is a list of some of my favorite narrative fallacies in investing:
- Because of “fill in the blank”, interest rates have to rise.
- Actually they don’t have to as we’ve witnessed over the past five years.
- The stock market can’t go up if the economy is weak.
- The link between GDP growth and stock market returns is, in fact, very weak.
- I’m better off buying instead of renting by building equity instead of “throwing money away” on rent.
- The assumption here is that the price of real estate is stable so that a dollar less of mortgage debt equates to a dollar increase equity, i.e. Price = Mortgage Balance + Equity Balance. The problem is that “Price” fluctuates and so will the equity balance even if the mortgage balance decreases as payments are made.
- It’s a good time to buy…
- dividend payers
- quality companies
- companies with a wide economic moat
- low-volatility stocks
- stocks of companies that begin with the letter “D”
- The narrative here is that there are obvious signals for when certain type of assets will perform better than others. A classic table below demonstrates, however, that relative performance is essentially random.
Source: Dimensional Fund Advisors
When you hear a compelling investment story, take it for what it is, a story. Then check the facts…Let’s Go Kings!!!!
is the founder and principal of Westchester, New York-based, Fifth Set Investment Advisors LLC, a Fee-Only, SEC registered investment advisory firm. Following a career in equity research, an examination of competing investment management approaches led Ian to create Fifth Set to offer clients customized wealth management strategies built on a foundation of evidence-based financial theory.