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Sunday, 10 May 2009

Fairy Tales for Investors

Storytelling and Stocks

Once upon a time there was a wonderful company with a magic formula which kept on growing forever and ever. Or so we’d like to believe.

The world we live in is saturated with stories for good reason – they're the prism through which we make sense of our lives. Stories, however, aren’t necessarily real and the ones we're told about stocks are as likely to be fiction as fact. Understanding the difference is critical if investors aren’t going to spend their lives as the stockpicking equivalent of Alice in Wonderland.

Language or Numbers?

Virtually all humans, no matter how badly damaged, learn language. To stop a person learning to speak you have to lock them in a cellar and deprive them of conversation for the first five or so years of their lives. Mathematics, on the other hand, is far from natural. Left to themselves most people would never get beyond one, two, err ... lots?

There’s a pretty strong argument that we construct our sense of identity through stories that we tell and retell over time. The research of Dan P. McAdams argues that identity is constructed out of stories:
I consider the life story to be an internalized and evolving cognitive structure or script that provides an individual’s life with some degree of meaning or purpose while often mirroring the dominant and/or subversive cultural narratives within which the individual’s life is completely situated.
Or: our lives are a story told by ourselves within the confines of our cultures. An Amazonian tribesman isn’t going to invest in Google, whatever story you spin.

Humans: Storytelling Animals

Basically humans are built to tell, understand and live by stories. That's all we had for tens of thousands of years until the Greeks came along, invented algebra and ruined generations of schoolchildren's lives.

When it comes to picking stocks we’re far better off with numbers than narratives but the former don’t resonate to the same effect as the latter because we're designed to work with stories not algorithms. So we tell tales to maintain our identity and are strongly motivated to ignore any actual evidence that contradicts them. This seems uncannily like the way that investors tell stories – to themselves and others – about their investing prowess: to convince themselves of their stockpicking abilities, no matter how much the actual evidence may be against them. Technically this is known as “cognitive dissonance”, the ability to hold two contradictory beliefs simultaneously.

Narrative psychology has no problem with cognitive dissonance – indeed, it may be essential to protect ourselves against the fragmentation of identity. If an individual’s core identity is bound up with the belief that they’re a good investor it may be easier for them to ignore their own failures in favour of some other story – that the market is illogical or that the company management are incompetent – rather than to admit their own shortcomings.

Suspension of Disbelief

Our liking for narratives is almost unbounded. We prefer conspiracy stories to the reality of simple cock-up. We will immerse ourselves in works of fiction, suspending disbelief, for hours. We will align ourselves with master storytelling politicians rather than think for ourselves.

Occasionally the world of fiction spills over into real life. In 1938 Orson Welles’ radio broadcast of War of the Worlds was enough to send people into hysterical overreaction. In the words of psychologist Jerome Bruner the story created a “narrative necessity” which caused people to respond "logically" - by panicking. Thus can stories change lives.

Bruner’s view is that unthinkingly accepting stories we agree with is an “effort-saving way of dealing with knowledge” – something we’re increasingly faced with in an information saturated world. It's a form of suspension of disbelief and the same effect holds for stockmarket storytellers. Read any analyst report and it’s impossible to avoid the narrative constructed to justify the recommendation. It’s the spiel, not the numbers, that's compelling in most cases.

Investing By Numbers

Unfortunately narratives are as much about constructing reality as reflecting it. All too often we’ll take a story as gospel truth rather than only one possible interpretation – that’s the skill of a convincing storyteller. Mostly the result of such decisions isn’t meaningful or obvious but when you’re backing your judgement with money it can make an awfully big difference to your wealth.

So, the obvious reaction to the human bias for a good story should be, you’d have thought, to fall back on the numbers. Ignore the tales told in results statements, analyst reports, newspapers and blogs. Focus on the accounts, the numeric evidence of performance. However, numbers are historic and often give no indication of future performance. Future performance is, of course, the only thing an intelligent investor should be interested in. Numbers can also lie, once the evil legion of accountancy gets its hands on them. There’s no safety in numbers.

Quantitative and Qualitative

Now readers will, no doubt, already have remarked on the oddity of a storyteller warning people about stories. But if we can’t trust in numbers either, what’s an honest investor to do? Anyway, we're so drawn to stories most of us can't avoid listening to their siren call, so we're faced with deciding which ones we choose to believe.

A wise manager once told me that the “quantitative comes from the qualitative” or: you don’t make money without getting your story straight. To be successful at investing we have to either find the right stories or remove the need to understand them at all. In a world of almost infinite narratives it’s not easy to do either. Our choices are limited.

Evidence of Past Success

Three themes emerge from the evidence of investors who've been successful on multiple occasions. I don’t mean the likes of Bill Gates or Richard Branson who are hugely successful businessmen but who've followed a single theme through their careers. No, it’s the likes of Templeton, Graham, Schloss, Knapp, Ruane and Buffett by whom the average stockpicker needs to plot their course - by looking at their deeds rather than listening to their words.

One theme is value investing – setting a numerical framework and then relying on regression to the mean to provide above average earnings. No story is required for such stocks. A second is identifying stocks that will be successful regardless of the stories that swirl around them, companies with businesses that will stand the test of time, regardless of the business challenges that face them: companies with defensible moats.

A final approach is to find the narrative that the market has latched onto and then bet against it. My favourite anecdote in this vein is of the octogenarian Sir John Templeton making his last fortune by shorting the stock of dotcom companies at the height of the 1999-2000 boom, timing his investments by when the companys’ directors options became due. The options vested, the directors sold, the penny (and the stock) dropped and Sir John made another packet.

And We All Lived ...

We're addicted to stories, especially ones we want to hear. Once we’ve committed to a stock confirmation bias kicks in – we want to believe anything positive and tend to gnore anything negative. We need to avoid the stories or find ways of getting them to help us – believing in them uncritically can do us no good whether they emanate from companies, analysts, media, internet bulletin boards or even blogs.

Because, unless we, as investors, can divorce ourselves from the stories while retaining a grip on the facts we can be sure that in our Fairy Tale there’ll be no Happily Ever After.

Related Posts: Financial Driving Tests, Darwin's Stockmarkets


  1. I was surprised by this paragraph of yours:

    Virtually all humans, no matter how badly damaged, learn language.
    To stop a person learning to speak you have to lock them in a cellar
    and deprive them of conversation for the first five or so years of
    their lives. Mathematics, on the other hand, is far from natural. Left
    to themselves most people would never get beyond one, two, err ...

    There is ample evidence for your first claim: nearly all children,
    around whom a (natural) language is spoken, learn to understand and
    speak it.

    What evidence is there, though, for "mathematics [being] far from
    natural"? Mathematics can be viewed (and is indeed viewed and
    practised, at least by many mathematicians) as a language but, unlike
    natural languages, it is not "spoken to" almost any children in any
    systematic and "natural" way when the language capacity in their
    brains is still malleable.

    Chomsky's hypothesis is that a "universal grammar"--common to all
    human languages--is embedded into the structure of human brain, and
    that this may explain children's capacity to learn any natural
    language as their own (and not necessarily the language of their
    biological parents) if exposed to it in early childhood. Is there any
    such hypothesis for (the language of) mathematics? If such a
    hypothesis had legs then it might have some serious consequences for
    the myth/truth universally acknowledged that "mathematics is far from


  2. Thanks for the comment. It’s a fair point and one that needs qualifying. Delving deeper would have made for an awfully long post, though ...

    One argument is that counting requires words for numbers and many primitive societies don’t have these words. Of course, that’s not the same as saying that there isn’t innate number ability in the brain – evidence suggests there is, although the development of abstract number theory may be another matter: it’s one thing to count “things” another to abstract to “numbers”. Complex language concepts appear to arise everywhere, independently. Complex numerical concepts, like ‘zero’, need to be invented and promulgated socially.

    Something worth another post with space for a more nuanced argument, I guess.

    On Chomsky it’s a while since I looked at this but I thought the idea of universal grammar had more or less been replaced – brain plasticity allows for many more complicated combinations of languages than it allowed for? So it’s less a grammar than a set of flexible heuristics?

  3. anonymous ought to read Steven Pinker. he has a good go at progressive immersive methods of teaching maths. you don't learn it through play, but only by some significant level of rote and slog. we do have some innate informal maths, which can be very subtle: precise intuitions of more and less, and of ratio: like children's finely tuned notions of fair shares.. but exact number reckoning needs effort.
    but he said something about how we're not so innately thick at maths as some think. if a problem can be couched in the right way, the right story, we're ok at getting the right solution.
    i very probably misuse his name... i too only go for the story when i read a book. i don't crack my brains over the detailed argument...
    now: any idea which way the markets are going?

  4. Why do all the kids like Fairy tales ?

    (A) Because of magic

    (B) Because of cartoon

    (C) Because of colors

    (D) Because of story

    To vote this question please click the link given below