The Narrative Fallacy is the idea that humans are predisposed towards believing a good story over understanding the facts of a situation. We are often drawn towards less desirable investments simply because they have a good story and then use the story to convince ourselves of the merits of the company in which we are to invest.
“It’s working. You don’t really need to understand how or why, just trust us, it works. We’ve figured out this secret and for a small sum of money, you can get in on it too. It’s really easy; you just buy today and watch the price go up! It won’t drop, or at least if it does, it’s sure to recover, because we know that stocks only ever go up in price.
The fact that we have some buzzwords scattered throughout our presentation means that we’re really smart. Artificial Intelligence is going to be the Wave of the Future. Innovation will transform our lives. Don’t ask how we know that this company will be the one to do it; just trust us that they will be.”
Depending on the level of your investing and financial market engagement, there’s a good chance you’ve heard of Cathie Wood and her investment practice ARK Invest. In their own words, Cathie Wood and ARK Invest believe that disruptive innovation is one of the biggest causes of rapid cost declines in products and services. These cost declines disrupt entire industries and the leading companies are forced to innovate or go out of business. ARK aims to identify successful innovation early and invests in companies that will be “on the right side of change” to provide long-term value to investors.
For the last few weeks, I’ve read and watched as many interviews with Cathie Wood as I can find. I believe her to be an intelligent, articulate, and transparent fund manager. I feel I understand her investment process and I agree with many of her views. It seems patently undeniable that the world changes over time.
200 years ago, international travel was largely restricted to those in the military or of a wealthy background. Today, the overwhelming majority of citizens will have traveled to another country at least once in their lifetime.
100 years ago, print media was the predominant form of information sharing. Today, it has largely been replaced by digital media.
50 years ago, it was still legal in the United Kingdom to discriminate between men and women in terms of pay and conditions of employment. Today, it is not.
The world is changing all the time; some trends are easier to identify and forecast than others. Healthcare, for example, is generally expected to improve decade after decade as we learn more about the human body. Penicillin was one of the major medical breakthroughs of the 20th century. Ark Invest believes genomic sequencing, gene editing, and molecular diagnostics will provide a similar quantum leap in the 21st.
Their team of analysts and researchers has explored genomics, space exploration, 3D printing, autonomous technology, robotics, and many other emerging economic and social themes and picked the companies they believe will be the leaders in these areas over the coming decades.
Do you really understand this or do you just like the story?
It doesn’t take a genius to know that many of these themes have the potential to dramatically reshape our economies and our societies for the better. Human ingenuity has taken us from living in caves and fighting with big sticks to developing advanced healthcare, education, and social structures. The journey has not, of course, been without tragedies along the way; but human progress has been seemingly irrepressible.
This is where the danger of the Narrative Fallacy comes into play. As an investor, I ask myself a few questions before making an investment. Firstly, is the company I’m examining likely to grow its revenues and profits in the future? Why do I think this likely? What are the potential risks to the company and my investment? Who are the competitors; what are the odds of them being even more successful than this company? Do I understand what the company does and how well?
I use Cathie Wood to highlight the point but in truth, I think she’s become a bit of a poster girl for a type of retail investor that is just begging to lose money. If I asked these questions to an unprepared, uneducated retail investor, their answers would nearly all rely on Cathie Wood and her team being right. These investors aren’t advanced gene experts or astrophysicists. They’re not the head of operations for a multi-national company considering the use of 3D printing. They can tell that these technologies have fantastic potential but what they can’t know, in which companies will manage to successfully commercialise and launch products in the space.
Many, many of the companies that are in ARK Invest’s funds are loss-making. They may well sell products and services, perhaps many millions of pounds worth, but the cost of staff salaries, research & development, distribution, and customer support means that selling them costs them more money than customers are paying for them. Of course, if these companies have large cash balances, they can fund this activity for some time, drawing down on their cash reserves, but eventually, one of four things has to happen.
- The company makes a profit, either by increasing prices or reducing expenditure.
- The company borrows money to fund continuing operations.
- The company sells more equity for cash, diluting existing shareholders.
- The company cannot afford to pay its bills and goes bankrupt.
As an investor, the best outcome is the first option but ask yourself this; what will happen if the company increases prices and loses customers because they don’t want to pay more? Likewise, how easy is it for the company to reduce expenditure without damaging their business? If you employ the leading scientists in the world on £100,000 a year and reduce their salaries by 20%, what is to stop them from going to work for the competition? Fine, you could force them to sign non-compete contracts, but now you’ve got a bunch of people working for you that don’t want to be there; hardly a recipe for success…
Still, you’re drawn to this idea that these companies will revolutionise the world. Imagine if you’d bought Amazon back when it was only $1.50 a share (it’s currently over $30). You could have been a millionaire! Cathie Wood has bought so many amazing companies that surely one of them will be the next Amazon!
Now you’re starting to sound less like an investor and more like a speculator. You want to believe the story and you don’t want to care about the fact that these companies are losing money. THIS is the Narrative Fallacy at play.