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Stories help investors deal with uncertainty and imperfect knowledge. But contagious narratives which come to dominate can over-inflate expectations - and therefore prices - until a new one challenges and eventually replaces it.

Stories have always influenced human behaviour: our decision-making is often driven more by a good tale than objective facts and data. But stories can defy reality only for so long.

Eventually, people trust the evidence of their own eyes and realise that the emperor’s new clothes are in fact his birthday suit. Such epiphanies can lead to abrupt regime change, which is why we believe investors should be aware of, and challenge, any prevailing market narrative before acting on it.

As social beings, humans are preoccupied with our own and others’ experiences. We think about these experiences in the form of stories, which reach into every part of our lives. Some are entertaining, such as jokes or heroic tales; others, such as theories or plans, are serious. We watch sports to witness stirring stories of victory and defeat. We are constantly bombarded by media stories, interrupted only by companies using narrative techniques to sell their products to us. Even when we sleep, stories appear to us in the form of dreams.

Why this ubiquity? It seems stories are hardwired into the way we make sense of the world. According to the neurological theory of narrative thought, our brains organise everyday sensations and experiences into a meaningful sequence of events, rather than a set of discrete perceptions. Our conception of time is therefore linear: the past influences our interpretation of the present and how it may shape the future. As Nassim Taleb says, narratives help us to make sense of the world so that it appears “less random than it actually is”.

The power of narratives

Communication scholar Walter Fisher developed the theory of the narrative paradigm: we use stories because they are more persuasive than logical arguments and more memorable than facts.

Studies have shown that, unlike other information, we process stories the same way we process first-hand experiences. This is because narratives invite us mentally to rehearse the actions within them. When you perform an action, the same regions of the brain are stimulated as when you read about that action.

But there are other reasons our brains have evolved to think in terms of narratives. One is evolutionary value. The ability to link previous experience to the present (Daniel stumbled into a lion’s den, and now he’s injured) is central to our understanding of causality, which can help us to extrapolate what may reasonably be expected to occur in the future (stumbling into a lion’s den will probably lead to injury). Thus we can avoid or mitigate risks or take advantage of opportunities that are not immediately obvious.

A second reason is that stories allow us to cut through complexity and uncertainty. Today, we consume more information than ever before. The average person processes as much as 34 gigabytes of information a day (the equivalent of over 100,000 words), and this is increasing by 5 per cent each year.

Because this vast amount of information is costly to obtain, store, manipulate and retrieve, we summarise and simplify it into stories. Whilst simplification can help, oversimplification can have costly consequences, not least in financial markets.

When narratives become contagious

Nobel Laureate Robert Shiller has greatly advanced our understanding of the importance of narratives in economics. The telling of a good story links up various bits of information into a coherent whole and creates a reason to act in certain ways. Stories sway decisions to hire or fire, to buy or sell, to spend or save. These individual choices, writ large, move markets and drive the business cycle.

In finance, behaviour is driven by expectations of future returns, and expectations are often driven by stories, particularly during times of heightened uncertainty. The simpler a story – the more it extends and agrees with our preconceptions – the more persuasive it is. A good story embeds itself in investors’ minds: the narrative becomes the expectation.

Narratives are powerful when enough people come to believe in them. Shiller draws an analogy with epidemics: “The most contagious economic narratives drive boom-and-bust cycles.” These narratives are generally oversimplified to the point where they are easily transmissible – and either wrong or at least exaggerated. And “when we believe a compelling story that turns out to be not true, we can end up holding assets worth far less than the story suggested”.

Current narratives driving financial markets

Some of the most contagious narratives are new, more resistant variants of old ones. For example, the narrative that ‘technology is taking over our lives’ is just the most recent modification of the technological unemployment narrative that has been periodically scaring people since the industrial revolution. The fear has always been of chronic unemployment as machines take peoples’ jobs and produce too much output.

The rise of automation, artificial intelligence (AI) and machine learning have altered the narrative from muscle power being replaced by machines to the wider concern of computers substituting for the human brain. For individuals, this technology narrative creates a growing fear of irrelevance. When transmitted more widely, however, such concerns can affect the broader economy by reducing people’s confidence to consume, invest and engage in entrepreneurship.

Multiple narratives can coexist, reinforcing or undercutting one another. Investors need to assess which will become the dominant narrative driving behaviour and ultimately markets. For example, the technology story is reinforced by the secular stagnation narrative. This theorises that growth and inflation will remain low indefinitely, because developed economies are plagued by an increasing propensity to save and a declining wish to invest. The narrative is powerful because it is grounded in our experience over recent decades.

Set against this is the counternarrative that the same technology could harbinger a ‘fourth industrial revolution’. In this scenario, further technological innovation will support continued strong growth and earnings, thereby justifying higher market valuations.

For decades, scientists have been warning that greenhouse gas emissions are warming our planet. But, as we have seen, narratives play a decisive role in motivating action, and the climate story was complex and discouraging. For one thing, the message emphasised the costs and burdens of climate policy ‘trade-off’. This negative narrative failed to compel action.

Then a counternarrative emerged. Economist Nicholas Stern proclaimed the “transition to a zero-emissions and climate-resilient world provides the greatest economic, business, and commercial opportunity of our time”. This new framing – of an optimistic, green transformation story – was based on the pace of technological innovation and disruption, which has substantially reduced the cost of producing renewable energy and storing it in batteries.

Strong narratives can drive market consensus and lead to crowded trades around major themes. Stern’s more upbeat message has not only encouraged people to act on climate change and other sustainability issues, it has also catalysed an ESG (environmental, social and governance) trade in markets. This trade has become prevalent not only because the story behind it is strong – the innovations in sustainable technologies and the promise of higher returns from investing in a better future – but also because the narrative resonates with so many different groups of investors.

Whilst it is clearly of benefit that so much capital should flow into tackling climate change and other sustainability challenges, such crowded trades can eventually lead to disappointing financial returns for investors.

Sailing against the prevailing

Stories help investors deal with uncertainty and imperfect knowledge. But contagious narratives which come to dominate can over-inflate expectations – and therefore prices – until a new one challenges and eventually replaces it. The technology and ESG narratives are compelling for several reasons, but they need to be justified by growth in revenues and earnings.

The challenge for investors is to be aware of, and to challenge, the prevailing dominant narratives and to watch for any signs of impending regime change.

*Charalee Hoelzl is an investment manager with Ruffer