CHG Issue #183: Narrative Fallacies

Wall Street's favorite bedtime stories: why your brain falls for market myths and your portfolio pays the price

Stories Follow Prices, Not the Other Way Around

The recent market turbulence provides a perfect case study of how narratives function in financial markets. A principle we often emphasize—"narrative follows price"—doesn't dismiss the importance of stories but reminds us to focus on the underlying processes rather than merely accepting the explanations that emerge after the fact.

Consider how analyst price targets consistently trail stock movements, adjusting upward or downward to align with current conditions. Despite their notorious inaccuracy, we continue to turn to them because they offer structure in an uncertain landscape. Their flaws stem not from poor methodology but from the inherent unpredictability of what they attempt to forecast. Yet we repeatedly turn to these "blind guides" because we crave compelling narratives that make sense of chaos.

The Cognitive Architecture of Narrative Fallacies

Narrative fallacies arise from our innate tendency to weave coherent stories from random events. This happens because our brains crave coherence, and we evolved as a culture through the art of storytelling. Therefore, the most believable stories, not necessarily the ones most grounded in fact, are what proliferated throughout history. This worked well in primitive times when the stories were about where the lions were hiding, however in our modern world the emphasis of believability over facts can be problematic, especially in financial markets.

Good stories possess a unique ability to captivate our imagination while disengaging our logical faculties. Consider this anecdote that a developer recently shared: a commercial property near USC sold for $40,000 in 1980 and recently changed hands for $8 million. The developer’s conclusion was obvious—USC real estate is an exceptional investment.

However, let's examine the facts surrounding this anecdote:

• $40,000 to $8 million represents a 200x increase over 44 years;

• This equates to an annual compound growth rate of approximately 10.7%;

• During this same period, the S&P 500 returned about 11.3% annually with dividends reinvested.

The reality is far less dramatic and compelling. If I had told you that the USC property performed in-line with the S&P there isn’t much to that story, however the $40,000 to $8 million numbers are easily anchored to and the length of time quickly forgotten. The USC property performed comparably to the broad market as its returns were likely influenced by the same macroeconomic factors that drove asset prices generally: interest rates, economic growth, and inflation.

But this sort of analysis is tedious and offers little actionable guidance about whether to invest in USC real estate today. So, we substitute the complex question ("What constitutes a good investment considering risk-adjusted returns across asset classes?") with a simpler one ("Could this developer 200x my money?").

The late Art Cashin famously pointed out that:

>"No one ever made a decision because of a number. They need a story."

>CNBC

At the root of these biases lies what psychologists call "attribute substitution"—our tendency to replace difficult questions with simpler ones. This mental shortcut is essential for daily decision-making but becomes problematic when more complex analysis is required.

Following the election, we witnessed substitution in the markets as investors answered the difficult question of what markets would do next year with the easier question of what did they do last time Trump was president. Tariffs were assumed to be merely a negotiating tactic, and it was assumed the US dollar and stocks would continue their dominance in the global marketplace under the strong-man leadership of Trump. Instead of listening to and analyzing what the incoming administration was saying about their policies, investors just extrapolated the market action from the first administration and confirmation bias took hold as investors eagerly consumed information that reinforced their pre-existing beliefs about Trump’s policies.

It didn’t take much effort to look past this surface-level analysis and see that the dollar fell shortly into the first Trump administration, but that wasn’t the pattern that investors wanted to see and it wasn’t coherent with the story that was being told, so it was ignored. The brain’s ability to simply ignore things is a very powerful force in the markets that should never be discounted. Consider that you do not see your nose despite it being in your field of vision; your brain has decided for you that it is not important and so it simply erases it from the image it gives you.

Once the issues that were hiding in plain sight became too big to ignore, investors experienced cognitive dissonance as the reality they believed in turned out to be very different than the one they were actually living in. This shock, combined with the weak structure of the recent advance created fertile ground for the sharp trade off we are currently seeing. But now, the same cognitive glitches continued working with a different effect.

The first emotional response to a significant change like this is retribution. Who can we blame for this and what can be done to fix it? This leads us back to the same experts whose misguided predictions led us astray in the first place. Technicians come to the forefront offering support levels, historical retracements, and all other sorts of predictions based on patternicity. Then the analysts come out saying that nothing fundamentally has changed, which is true because earnings are only reported on a quarterly basis. The knee-jerk reaction is to buy the dip, especially when it has worked for so long, but when the initial dip buying doesn’t work a new level of despair sets in.

We create a new concept, the “Trump Put” and ask ourselves is it gone? Headlines like “Is BTFD dead?” proliferate. Despite the fact that the illusion of understanding led us astray, previously we demand a new illusion that can help make sense of the chaotic world in front of us so we turn to new experts who can reassure us.

You can watch this unfold on the set of CNBC as the different market commentators are trotted out to offer their views. When prices are falling the perma-bears, like Jim Grant, are featured prominently, when prices are rising the perma-bulls, like Tom Lee, get all the airtime. The Great Man Theory of history resulted from our hardwiring for storytelling and is always on display in the financial markets. We mistake the best story tellers for those most likely to offer us a reliable antidote for the chaos of the markets.

Many famous investors have built their careers on the back of cognitive biases. Tom Lee has built his reputation primarily by promoting persistently bullish market forecasts during an extended bull market. His trajectory echoes that of Bill Miller, who achieved fame with an unprecedented 15-year streak of outperforming the S&P 500 by overweighting value stocks—particularly financials—leading up to the 2008 GFC. When the financial crisis hit, Miller's fund collapsed by 55%, and he stepped down from his position.

This demonstrates that these investors are merely products of their environment and displays the difficulty of being mentally flexible and adaptable to changing conditions especially after a period of prolonged success. George Friedman of Geopolitical Futures argues that history is shaped by broader forces, not the individual leaders that the Great Man Theory champions. These individuals are smart enough to identify and capture the zeitgeist of their time, but they are not uniquely gifted visionaries, they are merely the people who were there to capture that particular moment—if it wasn’t them, it would have been someone else.

Once again, this is a statistical fact that we are prone to overlook: if you run one million trials of flipping a coin ten times, you will inevitably witness many sequences of ten consecutive heads or tails. These aren't miracles; they're statistical inevitabilities.

Despite this we set our hopes on our leaders but as Trump and Bessent decline to offer the market support, resentment sets in, and we blame them for our predicament. We start looking to other markets that we believe to be leading indicators, like credit spreads, to see if the odds of a recession are growing and wonder why the administration would want to send the economy into recession.

The problem with these approaches is there is no reliable indicator for the future because the future is uncertain. Credit spreads today are heavily influenced by the stock market through hedging flows from institutional trading desks, therefore there can be a lot of reflexivity in the system where lower stock prices push the price of credit higher, which ends up causing a recession.

As the initial panic recedes, despair and eventually acceptance set it and it is at the moment when the future is bleakest, when the negativity seems like it will never end, that things change once again. Andy points out that we haven’t seen a market clearing event in a long time and we may be heading in that direction today. This is creative destruction, and it appears that Bessent adheres to the view that we need to reset the system to create a fertile environment for future prosperity.

Finding Edge Where Others See Only Stories

Narratives represent market beta—easily accessible explanations that provide comfort but rarely advantage. True edge comes from rejecting lazy assumptions and engaging with difficult questions through System 2 thinking. This recent talk between two Bridgewater alums pulls back the curtain a bit and shows how they viewed their edge: by finding and scrubbing the data—the dirty work that others didn’t want to do.

By critically examining stories and doing the mundane and dirty analytical work, investors can avoid the pitfalls of narrative fallacies. Jesus advised us to, "Enter through the narrow gate" and Rudyard Kipling said success would come "If you can keep your head when all about you are losing theirs," and finally Warren Buffett applied this wisdom directly to markets: "Be fearful when others are greedy and greedy when others are fearful."

The path to sound decision-making lies not in embracing comforting narratives but in a consistent and disciplined approach when emotional shortcuts beckon most strongly. The ability to recognize emotionally charged moments in the market and have a deep appreciation for the cognitive processes that govern these times is really the only discipline you need to be successful in the markets.

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