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Be wary of compelling stories

Understanding how narratives play on emotions can help with decision making

Should you make investment decisions based on stories? All investors do, to an extent. Some typical maxims might be 'buy the dip', 'buy after good news', 'buy after bad news', 'follow the insiders', and 'buy good companies and the returns will follow'. These are compelling because there is some truth to them – but none are foolproof. 

As Aswath Damodaran, professor of finance at Stern School of Business at New York University, pointed out in his book Investment Fables, investing is full of stories which sound good when they are told but don’t hold up under close scrutiny. He also says that investors are much more likely to be swayed by good stories than graphs and numbers. This is because most good investment stories appeal to a fundamental component of human nature, be it greed, hope, fear or envy. The pull of narrative is pretty much in our DNA. 

Investment stories are usually accompanied by studies that back them up, offering evidence of their vigour. However, as Damodaran explained, the evidence may only tell part of the story. And much of what is presented as incontrovertible proof of the efficacy of an investment strategy can fall apart on closer examination, for example, when applying the strategy to different subsets of history or changing the range of stocks examined. Rules of thumb can also become outmoded as market conditions change.

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