“Imagine how difficult would physics be if electrons had feelings” – Richard Feynman (Probably)
No one knows whether Feynman actually said it or not. Regardless, this quote captures an insane amount of truth. Investing unlike physics does not work on core rigid principles. If it had, Newton would not have lost most of his savings when he invested in the South Sea Company stock. Human beings unlike electrons are driven by emotions. And these emotions cannot be put into seamless and faultless equations. That is the reason even the most sophisticated of trading strategies don’t turn out well most of the time. Financial markets are a second-order chaotic system that changes itself (usually for the worse) once the first order has been figured out.
Part of what makes investing extremely hard is that the short-term trend of prices is mostly influenced by the collective psychology of the markets. And the long term is nothing but a series of continually occurring short terms. Thus, it leads to the unpredictable nature of markets.
Narratives
Narrative as what I mean here, are the stories that prevail in the public consciousness. Human beings are storytelling creatures. We think in stories and use them to make sense of the world around us. We tend to ‘storify’ everything in order to get a better and more efficient understanding of the world around us. Stocks are also ‘storified’ or put into easily understood narratives more often than not.
At any given amount of time, there is not just one but multiple stories going on around the minds of investors concerning a given security. And the most popular story (in terms of volumes) has a major say in deciding the valuation of the stock. If the stock is in a space that is considered legacy or outdated by the vast majority of investors, regardless of the earnings, the stock will not command a high valuation for at least a good while.
In addition, narrative feeds on narrative. Something that has a positive narrative tends to cascade into an extremely positive narrative due to the effects social proof and confirmation bias has on your brain. The bias is further worsened if the value of the security you own escalates. Price indeed influences perception. Something that increases in value attracts attention and people often who ‘hate to miss out’ also jump on the train. Similarly, negative sentiment tends to escalate into a depressive sentiment. That is the reason it is often easier to buy stocks in a bull run but not when chips are falling like dominoes.
These escalating narratives are only broken and brought down to their place only when investors are forced to accept the reality upon the realization that the stories they held in their brains were flawed. This leads to the formation of new narratives. Old narratives often fade over time to pave the way for new narratives.
The most important job of a wise investor is to think independently. And to not be influenced by popular opinion at every turn. In reality, it is hard to practice. Especially when idiots make money on things you ‘just know’ they shouldn’t be making even a single nickel on.
Getting sucked in Narratives
We tend to conflate the rising value of our investments with the ‘correctness’ of our decision. The truth is that we can be dead wrong, yet still make an insane amount of money on an investment (for a while). Vice versa is also largely true. This is largely due to the effects narrative has on the majority of the public. Stories can alarmingly grip the public. As you would have recently witnessed, It was very easy for a large section of the public to get sucked into the Crypto narrative when you have an over-enthusiastic set of supporters lifting the nominal value of the digital coins (which were largely scams or less understood).
Most investors who lack experience get more confident and courageous to act on their decision if an entire ocean of people agrees with them. Inexperienced investors inadvertently believe in the wisdom of the crowds when it comes to investing. That is how throughout history, trends have flourished without any rational basis or intrinsic value like the Tulip mania, dot-com boom, etc. ‘Fear of Missing out’ when combined with Social proof and Mania-fueled asset rise can be a very dangerous combination that can make even the soundest investor question his position again from time to time. God knows how much time I have spent thinking about the crypto space especially when they were rising like hotcakes. I was forced to question my own judgment every single day. But being value-driven and extremely stubborn, that space never made any sense to me and neither does it now. I might be wrong eventually on this space but over the years, I have learned that it is better to miss out on a great opportunity than get sucked into something that you don’t completely understand. Not losing money is way more important than making tons of it.
Narratives and Rationality
Human beings are not rational creatures. Neither are they completely irrational. To be honest, I cannot even define what rationality is. It is a highly subjective term. What seems rational to one might seem stupid to someone else. It is easier to put that human beings simply are. Most of the decisions they take make sense to them even though it might be absolutely nuts to someone else. And No one is completely crazy. But most aren’t completely sane either.
A great deal of outperformance and underperformance in portfolios can be attributed to Narratives. Since sentiment doesn’t have any impact on earnings, it does have an impact on valuations. PE (or high valuations) expansion is the most common outcome of that. Sometimes these narratives hold value and people who impose their faith on them are rewarded. And the rest of the time, they turn out to be duds. Weeding out the wheat from the chaff in this case is an important skill set an investor needs.
To their credit, narratives are the single biggest factor that makes the markets inefficient. If it were not for different stories floating around, Active investing would be dead (or probably be on a Ventilator). And neither would investing be any fun if everything was priced according to the DCF. It is the narratives that take the stocks to the moon and these same narratives depress the stocks into a deep hole. Markets are as much the psychology of the masses as it is finance and numbers.
Value and Narratives
Value investing is largely based on betting against Narratives that have made a beating on the stock price. And betting against the crowd is hard. You need an insane amount of confidence and self-belief to do that. Especially when your corporate career is on the line. There is shame and mockery along with financial loss waiting at the other end if you’re wrong. There is a reason why most mutual fund portfolios look like a copy-paste of each other. There is an inherent risk and shame of being wrong alone vis-a-vis being wrong along with the whole of the pack. Hiding behind the excuse of “market, on the whole, is down and every fund is down” is pardonable but being cracked in a bull run is inexcusable to most clients.
It is a common saying ” To buy when there is blood on the streets”. But how many follow it when the massacre is going on? Betting against the crowd is emotionally tough. The social proof of the opposite camp and the loneliness of your endeavor weighs on you. Bouts of self-doubt reoccur until the ticker tape moves in your direction. And those bouts are aggravated in case the ticker tape moves in another direction. And it not only doesn’t take its toll on the decisions you make but also on the ones in which you don’t. It is extremely painful to see nitwits making a fortune on something that’s likely fueled by narratives and has nothing intrinsic to it. It’s the job of a wise investor to not be driven into securities that are fueled by sensationalism. And that is indeed a rare trait.
That is a part of the reason that Value investing might sound easy on paper but is hard to execute. Not everyone has the mental fortitude to sit on a big nominal loss for a while on a lonely decision. Some even argue that being a value investing is genetic but that seems far-fetched to me.
Formation of Narratives
Narratives are hard to predict and can be formed in the unlikeliest of situations.
Sometimes they play out over many long years. History is littered with such examples. The Dot-com boom of the late 1990s was one such example. Any company having a website saw its stock price launch to the moon and IPOs oversubscribed by the clueless public. Crypto mania which occurred twice in a span of five years was another such example. It was hard to predict after the initial collapse of crypto coins in late 2018 that it would rise into public consciousness again within a couple of years. This showed without a doubt that extremely similar narratives can take place again on a global level. But for such trends to play out, there has to be a trigger on some Macro level. COVID lockdowns saw Pharmaceutical stocks surge violently, Real estate stocks in India ascended haplessly in the mid-2000s on the back of the Indian GDP growth narrative, and EV stocks (especially Tesla) went to absurd valuations on the back of an EV narrative. Rivian, an EV company that had not sold any vehicle yet listed at a valuation of 120 Billion USD. Of course, interest rates and liquidity helped in all of this but the narratives did play a major big part.
Sometimes, they can be formed in a short period and lose their sheen as quickly as they gain it. Hospital and Vaccine stocks cruised during the Pandemic. Although most of them didn’t have a significant impact on earnings, a large part of these companies grew well in stock price and fell as quickly as they cascaded.
In a few select cases, there is a big uptick in stock price largely due to a big singular event or news. Elon Musk once advocated the use of Signal(the messaging app) on Twitter. It turned out the Signal stock ( the company that was not even remotely related to the messaging app) went up 26 times in a couple of weeks. 26 times!!!! Let that sink in.
One major reason that certain narratives are blown into the stratosphere of absurdity is due to the entry of many uninformed investors who primarily act on avoiding regret, commonly known as FOMO (Fear of missing out). Letting an investment opportunity go by where most of your pals are making a killing presently is psychologically tough. And since we tend to conflate the rising value of assets with the ‘correctness’ of our decision, it is easier to get sucked into it. Something that is easily understood and agreed upon by the masses.
VC and Narratives
Another subset of investors who have used narratives very cunningly in recent years has been Venture Capitalists and Private Equity. Some VCs indulged in presenting Golden Retrievers as Lions by adding a cheap quality mane to it. IPOs are rarely ever fairly priced. Rather they are priced as extremely as possible. And most of the IPOs take place in a bull run. You can notice how IPOs have dried up on the first sign of an impending bear run.
VCs often chase higher returns by backing startups to achieve a big scale in a short period. Profitability takes a backseat and pseudo metrics such as TAM and revenue take the front seat for subsequent valuation rounds. They often need an exit if they find themselves dug down deep in a hole. Hence, IPOs are often used as a tool for VCs and the sort to book out the profits by unloading onto retail and sometimes, even sophisticated fund managers too. I am not vilifying the VCs here, but it is often good to be aware of the narratives they can use to their advantage in the name of ‘value creation’ via smartly broadcasted stories and narratives.
The takeaway
Remember, Human beings are storytelling creatures. We act and think in stories. It is just evident that we take this mental model of ‘storification’ into our investment portfolios. Stories are easier to understand than numbers. And certainly more fun to act on. But, markets are not just numbers, earnings, and interest rates. The market also reflects the value of public sentiment and earnings expectations. And those factors are quite fickle.
When you take narratives into account, it gets confusing and tough to evaluate your investing decisions. As a value investor, I tend to focus on earnings growth and business performance rather than an increase in stock price because that is a more robust metric of my performance. But sometimes, narratives that get formed around a certain security can help you achieve great returns in a short period.
It is important to take advantage when you recognize the stock price is not in sync with reality because of the stories that surround it. But it is equally more important to recognize the reality that those gains were largely due to factors that you could not have foreseen or predicted. Sometimes luck shines on you and it is important to recognize it for what it is.
As long-term investors, we try to predict earnings a few years well in advance and bet accordingly. And market usually rewards you if you are right even though sometimes the reward takes an extremely long time.
If I can add a few takeaways from my experiences over the years of seeing narratives play out in the market, they would be
- Think Independently
The job of a wise investor is to take into account different perspectives and think independently. It’s hard to do well in the markets if you base your investing decisions on the convictions of others.
- Understand your psychological tendencies
A lot of pain in the markets comes due to a lack of understanding of your emotional core and tendencies. Investing is more of a psychological slugfest rather than an analysis showdown.
- Study History and Psychological Biases
Those who don’t study History are bound to repeat it. It’s astonishing how much one can learn about human tendencies and crowd behavior just by reading broad patterns of how history took place.
- Narratives are not always right. Neither they are always wrong.
It often takes a lot of mental energy, effort, and discipline in order to get to the truth regarding something. A wise investor needs to put in time and effort to weed out the sound narratives from the absurd ones.
- Narrative fades and changes over time
Betting over narratives can be tough as unlike other robust metrics, they change over time. Sometimes rather very quickly. Sooner or later, reality will most likely catch up paving the way for new narratives. So, rather than betting on narratives, it might be more fruitful to know your individual investing positions. Sometimes the best way to deal with something is to ignore them. And that is what I try to do with narratives most of the time.