Investment Narrative Fallacy: Risks of selective facts

Have you watched the Martin Scorsese film “The Wolf of Wall Street”? If you haven’t, there’s a scene in which Leonardo DiCaprio’s character, Jordan Belfort, sells a narrative to naïve investors about penny stocks. Subsequently, the investors lose money on these stocks because the companies they invested in‌ had little or no value.

Belfort, a former stockbroker on whom the character is based, used something known as the narrative fallacy to convince investors. He put random events into a logical order to make them easy to process and his investors fell for it. Building tall stories of hefty returns to lure investors is not an uncommon tactic. Financial products that offer ambitious narratives without any historical track record could prove to be risky bets.

That is what former financial trader Nassim Nicholas Taleb said as well. In his 2002 book, The Black Swan: The Impact of the Highly Improbable, Taleb said, “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.”

What Nassim meant to say is that investors often look for logical explanations for a market event, though there could be none in certain situations. For instance, say a sectoral index zooms after weeks of decline. This could just be a temporary change due to foreign institutions buying in Indian stocks. However, if you take this movement to be the future market trend and take abrupt investment decisions such as fund switches, your long-term wealth could be at risk. It is this narrative fallacy that motivates investors to buy or sell investments.

How to spot fallacies?

Everyone has their biases, be it your friends, relatives, work colleagues, or investment salesperson. Sometimes, you may be sold an underdog story to make an investment. For example, an Ulip fund with moderate returns cannot offer sky-high returns when the underlying investment is volatile. But there could be salespersons who sell the narrative fallacy or promise of double or triple the returns in just five years. As an investor, it could be beneficial to look beyond these promises.

In such cases, looking beyond what is being presented could be advantageous. Here are two factors to consider:

Company history: Brand new companies with little or no information about the past. Every sector has an underdog. In fact, there is a category of mutual funds called contra MFs that invest in such sectors and companies. But these investment strategies are backed by years of research and concrete data. As an investor, you may lack the information to deduce a company’s future. For instance, during geopolitical situations such as the Russia-Ukraine war, your narrative fallacy could push you towards mutual funds exposed to defence stocks. However, not all defence companies stand to benefit from such conflicts. So how can you choose what company to invest in? By looking at its history, revenue, profitability, future growth estimates, and past defence deals.
Historical returns: Instead of relying on external sources for information, you could refer to official disclosures by companies. Insurers and mutual funds are mandated to disclose the NAVs and returns on a periodic basis. This means that you have reliable information to make investment decisions. The same applies to anyone promising steep returns. For instance, the housing sector benefits if the RBI cuts interest rates. The narrative fallacy may trick you into believing that this is the sunrise sector and hence all real-estate focussed mutual funds could add value. However, some of the real estates could carry high debt and therefore be unaffected by interest cuts. No two instances or companies are similar in the world of investing.

While it is beneficial to do your own research, Standard Chartered’s wealth podcast is another avenue to help you make informed decisions.

Correlation≠Causation

Sometimes you may also confuse correlation with causation. This is also caused by narrative fallacy because we believe certain things happen exactly the same way all the time. For instance, the Indian and US equity markets are connected to some extent. So if there is an IT boom in the US and the Indian IT sector also rises coincidentally, it is not a result of the American boom. Maybe the Indian IT sector firms rose because they won big projects or because they had strong quarterly earnings. So, investing in IT sector equity funds simply based on this one factor could become a risky bet.

Another example is the consumer sector. You may avoid certain sectors based on seasonal demand. For instance, products such as air-conditioners and refrigerators are purchased in summer and, therefore, related companies could report higher growth during those months. The same goes for aerated beverages and ice cream. But that does not mean that ACs and ice creams don’t get sold in the winter months. So there may be no rationale to avoid FMCG/FMCD-focussed mutual funds during this period.

Making decisions on narratives and preconceived notions may lead to losses. The track record of the company, the fund manager’s performance history, and macroeconomic conditions. These are just a few of the factors to be considered. As it is commonly said, don’t judge a book by its cover.

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Disclaimer:

This article is for information and educational purposes only. It is meant only for use as a reference tool. It has not been prepared for any particular person or class of persons. The products and services mentioned here may not be suitable for everyone and should not be used as a basis for making investment decisions. This article does not constitute investment advice nor is it an offer, solicitation or invitation to transact in any investment or insurance product. The value of investments and the income from them can go down as well as up, and you may not recover the amount of your original investment. Prior to transacting, you should obtain independent financial advice. In the event that you choose not to seek independent professional advice, you should consider whether the product is suitable for you. You should refer to the relevant offering documents for detailed information.
Standard Chartered Bank is a distributor of mutual funds and referrer of other third party investment products and does not provide any investment advisory services as defined under the SEBI (Investment Advisers) Regulations, 2013 or otherwise. Investments are subject to market risk. Read scheme related documents carefully prior to investing. Past performance is not indicative of future returns.