If you watch the evening financial news or listen to daily business radio shows, you will be given the comforting idea that there is always an explanation for whatever happens in the markets. Whether it’s the stock market going up or the rand going down, or neither doing very much, the pundits always have a reason.
This is not just because those who believe themselves to be experts never want to admit that they might not always know why markets behave the way they do. It is our human nature to create coherent stories from what we see, and we do it all the time without knowing it.
Nassim Taleb, author of The Black Swan: The Impact of the Highly Improbable, calls this the narrative fallacy; our impulse to assign reasons for everything that happens, even when the evidence is flimsy. This is how we make sense of the world – we are faced with so much information that we need to put it in some sort of order to be able to process it.
In simple matters, this is important. If your hand is burning because it’s too close to the fire, it’s critical to realise that cause and effect. In more complex matters, however, its accuracy erodes.
The roll of the dice
Our minds also revolt against the idea that chance and luck play an extremely large role in how the world works. In his book – Thinking, Fast and Slow – Daniel Kahneman, one of the fathers of behavioural science, uses the example of the incredible success of Google to illustrate this.
The story most often told, and most easily believed, is that Google’s founders are visionary geniuses who turned a new idea about how to search for information on the internet into one of the most valuable companies in the world. This narrative details how Larry Page and Sergey Brin made brilliant business decisions and developed a culture within the organisation that explains their ultimate success.
“Unfortunately,” Kahneman writes, “there is good reason to believe that your sense of understanding and learning from the Google story is largely illusory. The ultimate test of an explanation is whether it would have made the event predictable in advance.
“No story of Google’s success would meet that test, because no story can include the myriad of events that would have caused a different outcome.”
Without diminishing Page and Brin’s accomplishments, there were many possible things that didn’t happen, and many times when bad luck could have disrupted their business, but didn’t. These are simply unknown, and nobody, including the founders themselves, could have foreseen the outcome. Luck and chance played an enormous role.
Humans, however, don’t like that idea. We far prefer to believe the story that Google succeeded because of Page and Brin’s incredible foresight, and the company’s entire evolution can be explained that way. Since it turned out a certain way, we see that as inevitable.
It’s an illusion
Kahneman calls this the ‘illusion of understanding’ – our predisposition to build stories from the information available to us. And the better the story is, the more likely we are to believe it.
This doesn’t, however, just shape our view of the past. As Kahneman notes:
“The core of the illusion is that we believe we understand the past, which implies that the future should also be knowable.”
This is where things get dangerous, particularly for anyone listening to people like financial pundits. Because if we can assign reasons to everything that happened in the markets today, then that means we must be able to predict how they will behave in future. We believe we can see patterns of cause and effect.
“The idea that the future is unpredictable is undermined every day by the ease with which the past is explained,” Kahneman writes. “As Nassim Taleb pointed out in The Black Swan, our tendency to construct and believe coherent narratives of the past makes it difficult for us to accept the limits of our forecasting ability.”
Humans, however, have been shown time and time again to be extremely poor at predicting the future. There is perhaps no more devastating proof of this than Philip Tetlock’s 20-year study of 284 experts, who he asked to make more than 80 000 predictions on global events. Their forecasting ability turned out to be worse than random.
Telling a tale
Studies like Tetlock’s (and there are many), have not however stopped the media and people in general from seeking out expert predictions. On the contrary, there is a whole class of people who make a lot of money from giving forecasts, whether about politics, technology, finance or even sports.
And the more confidently they deliver those forecasts, the more likely they are to be believed. Certainty is seen as a sign of expertise, but is really mostly a function of having a good story.
“Overconfident professionals sincerely believe they have expertise, act as experts and look like experts,” notes Kahneman.
“You will have to struggle to remind yourself that they may be in the grip of an illusion.”
The world, Kahneman reminds us, is unpredictable. Chance and luck play a far bigger role than any of us like to acknowledge. That is worth remembering when any ‘expert’ insists that a particular asset class is undoubtedly going to perform in a certain way, or that a particular market is facing an inevitable outcome. Just because they have a good story to go with their prediction, doesn’t mean they will be right.