When it comes to storytelling, we have a long and venerable history of narrative. The spoken word emerged millennia ago — before even the Greeks — when the only way to share knowledge was verbally, person to person, generation to generation.
It is in your DNA to love a good story. You know, neat tales with heroes and villains and conflicts to resolve. A good story pushes our buttons, is exciting and memorable.
It should come as no surprise that Wall Street also loves a good story. And when Wall Street spins a yarn, its emotional pitch drives sales.
In the parlance of the Wall Street brokers, these are called “story stocks.” You have heard them: A new CEO is bound to turn the company around. The FDA was about to give Phase 3 approval to a miracle drug with a billion-dollar market. A sexy new product launch was going to catapult the stock price. And everyone’s favorite fish tale: the imminent takeover play.
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Of course, many of these stories turn out to be wrong. Surprisingly, that is not what gets us into trouble as investors. As it turns out, it doesn’t matter whether a story is true or false. It may be counterintuitive, but even true stories can end up being money-losers.
What matters most to you as an investor is the entire concept of the narrative. You have a natural tendency to want an emotionally satisfying tale — and to make investments based on that — despite times when the actual data may be telling you something different.
Consider a few examples of these stories. I recall in the early 2000s the “Apple is going out of business and what the heck is an iPod anyway?” story. (AAPL shares were $7.50 at the time). The updated version was how cheap Apple was at $700 given its low P/E ratio (or price-earnings, how the company’s share price compares to its per-share earnings). In this case, the data suggested looking instead at the slowing growth rate.
Or consider the gold narrative — it was going to hit $5,000 because of the Fed’s quantitative easing program. Well, the Fed is still doing QE but gold has fallen as much as 30 percent from its highs. Guess they need a new narrative. (Maybe this one will have more staying power.)
How many people have been calling for a market crash now for several quarters if not years? Cullen Roche of Pragmatic Capital describes what may be the biggest narrative failure: the Fear Trade.
“If you’ve been paying attention over the last few years, you probably remember how many people predicted hyperinflation, surging bond yields, soaring gold prices, a cratering U.S. dollar and a collapsing stock market. This was the fear trade. You overweight gold, short U.S. government bonds, short the USD, short equities and laugh all the way to the bank. On the whole, that trade has been a big disaster. In other words, fear lost out — again.”
He is right: None of those things has come to pass. Even worse, the fear traders have missed a 150 percent rally to all-time highs in the U.S. stock markets. While sell-offs are painful, over the long haul they tend to be temporary. The mathematics of asset class mean reversion is inescapable. Stocks will eventually recover, but if you fail to participate in a generational rally of this magnitude, it can set back your retirement by as much as seven years.
The simple reality of life is that everyone is wrong on a regular basis. By confronting these inevitable errors, you allow yourself to make corrections before it is too late. Traders are fond of the aphorism “It’s OK to be wrong, but it’s unacceptable to stay wrong.”
And expensive as well. I am fond of pointing out that cognitive dissonance is a very costly hobby. As many of the above mentioned narratives have failed, few are willing to admit error and face the music. Instead, they double down and make further bets. “I am not wrong, just a little early!” is the hopeful mantra of these cognitive dissidents. The Dow will sink to 5,000 eventually. The dollar will eventually collapse (along with the rest of the “fiat currencies.”) Hyperinflation is around the corner. Gold is gonna hit $10,000. Don’t blame me when the Great Recession II comes!
It’s not that any of these things is specifically wrong — they are all possible outcomes — but rather, the problem is the reliance on narratives that are by design money-losing stories, torturing the data or ignoring it entirely.
Here is my favorite astonishing (but by no means surprising) data point: As of the middle of 2012, in self-directed 401(k) plans, “The biggest single equity holding was Apple … followed by the SPDR Gold Trust,” according to U.S. News.
That’s what you get by investing by a well-told if erroneous and unsupported story.
What narrative are you following?