How “Narrative Bias” Short Circuits Your Investing Logic
Just because it’s a good story doesn’t mean it’s a good stock.
In this article, we’ll cover narrative bias — which plays on the innate human desire to view the world through stories.
Author’s Note: This article is part of my series on investing psychology:
12 Common Mistakes That Can Destroy Your Investing Profits
Learn how successful investors avoid cognitive traps and build a winning mindset.
Narrative Bias — What is it?
Narrative bias is the tendency of investors to view investments through the lens of a narrative, forming a simple story and ignoring data that doesn’t fit the story.
How does narrative bias apply to investing?
Investors tend to prefer investments that can be understood through a memorable or compelling story.
For example, which of these stocks sounds like a more compelling buy to you?
- A small cap technology company with stagnant sales growth and eight straight quarters of earnings losses has declined 50% from its 52-week high and now appears undervalued based on a range of well-established valuation metrics.
- A struggling company that builds next-generation military technology just hired a brilliant new CEO to take over the firm and engineer a fast turnaround. During an interview today with CNBC’s Jim Cramer the CEO said:
“I’m 100% confident in our turnaround. We’re going to double our investment in research and development and design new military technology that will completely transform the United States Army. You have a once-in-a-lifetime opportunity to buy our stock today in a half-off sale!”
Now, both companies are completely made-up situations.
But the interesting thing is they could easily be the exact same company, just described in two different ways!
The first description of the company focuses on data by discussing sales, earnings, 52-week return, and valuation metrics. It’s kind of dry and boring.
But the second description is much more exciting, focusing on next-generation military technology, a half-off sale, and a smart, confident, fast-talking CEO on CNBC.
There’s no right answer to the question above, simply because it’s made up and I didn’t give you enough information to make a real decision.
But the point is to watch the way your mind responds to the narrative description. It’s much easier to buy into and get excited about.
This is one of the reasons “story stocks” tend to get so hot. Investors fall in love with the narrative and eagerly buy in (usually at sky-high prices).
What should you do instead?
There’s nothing wrong with narratives. Often the story behind a company is an important consideration.
But where investors get in trouble is when they prioritize the narrative over the data.
Based on my experience, the data is much more likely to predict a good investment than the narrative.
When researching investments, you don’t have to ignore the narrative behind your investment theory. But you should look for data that supports or contradicts it.
“Have I analyzed objective data and information that could help prove or disprove my theory around this stock?”
If you think a hot tech stock is going to take over a segment of the market, scrutinize their sales growth, number of customers, asset turnover, etc.
If you think a steady health care company is going to boost earnings by cutting costs, compare their costs to industry peers, look at their past margin growth, etc.
Whatever you do, be sure to look for data that can both confirm and contradict your narrative.
Disclaimer: This article is provided for informational or educational purposes only and is not any form of individualized advice. All information is obtained from sources believed to be reliable but cannot be guaranteed for accuracy or completeness. Use this information at your own risk.