From the April 2014 issue of Research Magazine • Subscribe!

Warning: Powerful Narratives Can Be Hazardous to Your Portfolio

The dark side of investment stories

Investors should maintain a healthy level of skepticism when encountering a convincing narrative. (© Jonathan McHugh/Ikon Images/Corbis) Investors should maintain a healthy level of skepticism when encountering a convincing narrative. (© Jonathan McHugh/Ikon Images/Corbis)

Everyone loves a good story. Not only can a good story hold our interest, it can carve out a permanent place in our memory and change how we see the world. A powerful narrative about an important topic can inspire us to action.

But there's a catch. In order to convert the messiness of the real world into a compelling and moving narrative, some facts have to be elevated in importance, some discounted and others completely ignored. This can be helpful or dangerous, depending on our choices. The late Stephen Jay Gould eloquently lays out our challenge:

“We are story-telling creatures, products of history ourselves. We are fascinated by trends, in part because they tell stories by the basic device of imparting directionality to time…. But our strong desire to identify trends often leads us to detect a directionality that doesn't exist, or to infer causes that cannot be sustained.”

Investors should maintain a healthy level of skepticism when encountering a convincing and powerful narrative because of its potential to create an inaccurate, incomplete or false reality. By illustrating each of these potential perception traps, we will see how easy it is for a narrative to mislead even the smartest, most sophisticated individuals.

First let's consider the most common example of an inaccurate narrative: the daily headlines. It is well-established that financial markets reflect economic change, government policy and political upheaval. But these are broad sweeping relationships that play out over long periods of time—and our understanding of those relationships becomes clear only in retrospect, often years after the fact.

Connecting daily market changes to a seemingly related news event creates the inaccurate impression that short-term market behavior is related to easily identifiable and understandable causes. This is nonsense; but the effect of the repetitive message is almost impossible to ignore and the result is another generation of investors condemned to making poor choices. For a more extensive treatment of this issue, see my June 2013 column.

Yale Model

Second is a familiar and notable example of an incomplete narrative: the Yale Endowment Model. Developed and managed for nearly 30 years by David Swensen, it revolutionized the way endowments and institutions invested. Yale de-emphasized traditional stocks and bonds in favor of hedge funds, private capital, real estate and commodities. The model appeared to be invulnerable until it lost 25% of its assets in the market collapse of 2008. And while it has recovered nicely since then, returns have not been nearly as sensational as in the past—which has led observers to pose the inevitable question: “Is the Yale Model dead?”

Swensen and his team made a total break from the conventional wisdom of the time. This was a risk not just in terms of moving into more illiquid and less familiar investments; it was a huge risk of perception. If Yale failed, not only would they suffer from the underperformance of their investments, they would suffer from the disaffection of alumni who could withhold billions of potential donations from the endowment managers as a result of their failed “experiment.”

That part of the Yale Model has not been emulated. Ironically, despite endowment managers’ high level of sophistication, they continue to face immense pressure not to risk being too unique. A quick glance at the average college endowment today would confirm that—everyone is doing a variation on the same theme: the Yale Model, or at least the conventional narrative of what the Yale Model is.

But, as we now know, the Yale Model was not just the decision to expand asset classes. The real Yale Model was the decision to focus on making the best possible investment choices, wherever that might lead, and irrelevant to how it might be perceived either by alumni or other endowments. That is the real Yale Model—and it is most certainly not dead.

Barter Myth

Narratives are so useful they can inform our fundamental understanding of an entire field of study. But the trap of a powerful narrative is that it continues to inform our beliefs and our behavior, even in the face of enormous evidence that the basis of the narrative is false. This brings us to our final example: the myth of the barter economy.

This narrative exists in one form or another in almost every economics textbook since Adam Smith's The Wealth of Nations was published in 1776. The idea is so sensible and rational that it resonates with virtually everyone who reads it. It goes something like this: Centuries ago, or in more primitive economies, before the advent of money or credit, when an individual needed to acquire something he couldn't make or grow himself, he had to trade (or barter) something for it. Obviously this was inefficient and cumbersome, but as societies become more sophisticated coinage was introduced, and then ultimately credit (virtual money) and its many variations brought us to our current advanced economic state.

In his book, Debt: The First 5,000 Years, David Graeber provides numerous versions of the narrative, quoting one economics textbook after another. He writes: “This story, then, is everywhere. It is the founding myth of our system of economic relations…. The problem is there's no evidence that it ever happened, and an enormous amount of evidence suggesting that it did not.”

Graeber's well-researched book reveals that anthropologists have been pushing up against the barter narrative for over a hundred years. The anthropological authority on barter, Cambridge University's Caroline Humphrey, wrote: “No example of a barter economy, pure and simple, has ever been described, let alone the emergence from it of money; all available ethnography suggests that there has never been such a thing.”

Historians, archaeologists and anthropologists evaluating and translating 5,000-year-old cuneiform documents from Mesopotamia, discovered an economy not of barter or coinage, but of credit. Graeber explains: “In fact, our standard account of monetary history is precisely backwards. We did not begin with barter, discover money, and then eventually develop credit systems. It happened precisely the other way around. What we now call virtual money came first.”

The narrative of barter will not die easily because it sounds so sensible, so logical—and it follows the observable reality in nature that things generally progress from simple to complex. This is the trap of a false narrative: It plays to our instinctual need for things to make sense. And making sense of things is a powerful way we understand the world around us.

But the fact of the matter is that the real world is complex, and some of that complexity doesn't always make sense. Mark Twain's great insight, “Truth is stranger than fiction,” reminds us that reality often operates under rules that can appear nonsensical. Our job as investors is to acknowledge and accept whatever rules the real world goes by and use that information to our advantage. And if we feel more than a little uncomfortable in the process, our unease is a cost well worth enduring if the benefit keeps us grounded firmly in reality.

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