Mental pitfall: Narrative Fallacy

January 29th, 2008

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Today, we will continue with the series on common mental pitfalls that can lead to fallacious reasoning (see Common mental pitfalls that leads you astray for a compilation of this series of articles).

The topic we will cover today is Narrative Fallacy. In Nassim Nicholas Taleb?s book, The Black Swan: The Impact of the Highly Improbable, he wrote:

The fallacy is associated with our vulnerability to over-interpretation and our predilection for compact stories over raw truths. It severely distorts our mental representation of the world; it is particularly acute when it comes to the rare event.

In the previous mental pitfall, Lazy Induction, the fallacy lies in incorrectly inferring about what lies outside of what can be currently seen. For this mental pitfall, the fallacy lies in inferring about what lies inside of what is currently seen. Narrative Fallacy is a natural human weakness because by default, our minds seek to form theories, jump into conclusion, seek judgements and explain what we see. It takes a conscious act will to do otherwise.

Why do we fall into the trap of Narrative Fallacy? This is because our minds naturally seeks to simplify the myriad of  (often random) facts and figures into some kind of order so that it can be more easily stored and processed by our brains. The implication is, as Taleb says,

… the same condition that makes us simplify pushes us ot think that the world is less random than it actually is.

It also makes affect the way we remember past events. Historical events that fit our simplification into a story can be remembered better those that lies outside the story. That very simplification makes us think that what happened in the past is more predictable they actually are. When we extrapolate this illusion into the future, it gives us the illusion that we know what is going to happen in future better than what we actually can. This blindness is where Black Swan occurs. As we said before in Failure to understand Black Swan leads to fallacious thinking,  this can lead us to believe that we know a lot when in reality, we know very little.

Narrative Fallacy also affects our ability to estimate the probability of Black Swans. Black Swans events that exist in the form of stories (e.g. heard on television) are likely to be overestimated. Those that is outside the realm of stories (e.g. the ones that nobody talks about it) are very likely to be underestimated. Therefore, we often tend to overreact to low-probability outcomes that were discussed (i.e. exist in the form of a story) and neglect those were not brought into direct awareness. For example, we tend to overestimate the probability of another September 11-style terrorist attack and neglect other threats that are still as dangerous as ever e.g. Bird Flu pandemic.

How does the Narrative Fallacy work out in the world of investing? Whenever the market moves, you will notice that the news media feel obligated to give the ‘reason.’  Our earlier article (November 2006), How much should we listen to the financial media? is an example of a Narrative Fallacy at work.