People love stories. In fact, stories are how we have made sense of the world ever since we developed the capacity to share them.
Being able to identify a cause-and-effect narrative is one of the reasons that humans have been such a successful species. For example, we gained a lot by understanding that striking a piece of flint led to a spark, and that a spark could set a fire.
Even though the world is now a far more complex place, being able to construct narratives is no less important. It may even be more so.
There is so much information around us that we need to be able to simplify it into cause-and-effect in order to make sense of it all.
The need for narrative
The psychologists Nancy Pennington and Reid Hastie have studied this in jury trials. They found that juries respond more favourably to evidence that is organised as a story.
‘Our work showed how people take the facts at hand and create causal models to make sense of them,’ Hastie noted recently. ‘We even fill in missing pieces if they fit logically with the information that we have been given.’
This is equally true in financial markets. These are inherently complex, and nobody can consistently predict the short-term movements of share prices. Yet, we are constantly constructing stories to explain what we are seeing.
Testing Tesla
For example, why has Tesla’s share price gone up so dramatically this year? It is not difficult to appreciate that the Covid-19 pandemic has accelerated the move to green energy, and that Tesla is uniquely positioned to benefit from that.
Even though we know that there are highly complex dynamics at play in any share price, it is comforting to think that we can understand Tesla’s incredible run on this basis. It is a revolutionary company, and the surging share price is just a reflection of that.
Yet, at the same time, Tesla is the most shorted stock in the world. In other words, there is a counter-narrative that believes that the stock is grossly over-valued and that there are significant risks that it may fall.
At face value, these views can’t both be true. Something can’t be both a great company and a risky investment. That would be an incoherent narrative, and so our minds want to reject it.
Yet, in markets, this is perfectly possible. And, in this case, both views do have merit. In fact, Morgan Stanley expressed both of them recently in the same research note.
Cognitive dissonance
This is one of the reasons that markets are so difficult to forecast. There is always some kind of tension at play. That is, after all, what makes markets work – for every buyer, there must be a seller.
This is extremely difficult to reconcile, because of what is known as ‘cognitive dissonance’. For the most part, when we come across two apparently contradictory ideas, we have to discard one of them in order to maintain a logical narrative about the world in our heads.
This is useful for simple problems. For example, if the lights go out in your home, you know it must be either because you forgot to pay your bill, or because there has been a power failure. The chance of those both being true at exactly the same time is so small as to be insignificant. So you can comfortably settle on one explanation or the other.
However, financial markets are not simple systems. Many things, some of them apparently contradictory, can all be true at the same time.
A first-rate mind
This is why building portfolios based on a single idea, or in expectation of a single outcome is so risky. In the case of Tesla, for example, if you believe only that the company is going to be the most successful car manufacturer in the world, then you might be happy to buy and hold the stock at any price. However, that would require you to discard any possibility that the risks facing the company could have a significant negative impact.
The great American novelist F. Scott Fitzgerald is credited with noting that: “the test of a first-rate intelligence is the ability to hold two opposed ideas in mind at the same time and still retain the ability to function”.
The only way to do that in financial markets is to diversify. For instance, if Tesla’s share price does continue to surge, you don’t want to miss out. But if it collapses, you also don’t want to be too heavily affected.
A diversified portfolio does that for you. And the simplest way to diversify is to buy a broad index tracker. That way you are always holding all the competing ideas that may be in the market, all in one place. And no matter what plays out, you will capture it.