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Reality or fantasy – the narrative bias in investments

by James Chu
02/03/2018
Reality or fantasy – the narrative bias in investments

We love hearing stories. In fact, we like it so much that we tell stories to ourselves, some of which are often made up or “fake” to justify our actions.

Psychologists have found that human beings tend to defend an event, a belief or a view with logical “reasons” (note the quotation marks). The technical term is known as narrative bias. We have such biases because we believe all things should happen for a reason. We link causes and effects with our own stories, even if they are wrong. In other words, we manufacture our own reality.

Recently I was speaking to investors and advisers who were hesitating in investing. Their reason for their hesitation is that the FTSE 100 is too high.

 Let’s examine why they have such views.

The FTSE 100 continues to rise since June 2016, despite the of results from the EU referendum. This seems wrong to many people, so it is prone for a correction. Why? We have uncertainty in Brexit and the IMF’s forecast of economic growth in the UK was quite dismal (1.7% in 2017 and 1.5% in 2018). Investors believe that this is the rational that justifies the decision to holding off from investing.

I would however caution people with such a negative view, which has been driven by narrative bias. Put it more bluntly, I argue that we are terrible in understanding why the markets are performing so positively now, and I doubt we can get our “stories” right in forecasting the future,

To demonstrate, I have asked three colleagues (known as A, B and C) to rank the 5-year historical performance in six different stock indices without referring to any data source. My colleagues deal with investments every day, so they should be quite knowledgeable on the performances of the 6 different stock markets. You can say that a sample of three is not scientific enough, but as a quick and dirty research it at least gives us a rough picture of how they thought each one had performed.

The results are shown in Table 1 below. The lowest performance index was allocated a 1, with 6 deemed to be the best performing index and this is compared to the actual results as reported by Bloomberg.

A few points immediately stand out.

MSCI Emerging Market index was in fact the worst performing index. However, ne of my colleagues remembered the short-term strength of emerging markets, and thought it also implied that it was doing well over last 5 years.

The FTSE 100 was NOT the worst performing index, Bloomberg report it as second last, but two of my colleagues believed that it was the weakest link.

The Japanese market actually performed better than US stocks. This was despite the country being weak in economic growth globally.

Following on from the logic of those who think that the FTSE 100 is too high, then the Topix index should be more prone to a correction. On the contrary, many fund managers have turned positively to investing in Japan. This is because fund managers do not just look at economic growth, they also look at potential earnings of the companies. If the global economic recovery continues, then Japan will benefit due to the importance of export to its companies. Following last year’s election victory, Abe’s reforms should continue to go through which will benefit future economic prospects.

We are all bothered by uncertainty on Brexit, but we should not those worries overshadow what is important for investment. The true reality is earnings of British companies. We should not get carried away by the stories that we tell stories to ourselves, some of which are often made up or “fake” to justify our actions.

Table 1             Guess on price return ranking of indices (Dec 2012 to Feb 2018)

 

A

B

C

Bloomberg

Actual price return over period (%)

FTSE 100 (UK)

1

1

5

2

30.49%

S&P 500 (US)

6

5

6

5

102.44%

Topix (Japan)

3

2

1

6

122.27%

MSCI World

5

3

4

4

68.07%

MSCI emerging market

2

6

3

1

18.69%

EuroSTOXX 50 (Eurozone)

4

4

2

3

39.80%

 

Our investment specialists are more than happy to debate with you what is the true investment reality. We can be contacted at 020 7397 2597 or investments@reyker.com


James Chu

James Chu

James is Director of the Markets and Investments Team at Reyker. A CFA member and industry expert, James specialises in Structured Products, derivatives and development of service offerings for Reyker. A face at most industry events, James is sure to provide insight into some of the most controversial topics in the market today.