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.
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.