Fooled by narrative fallacy

August 18th, 2008

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This month is the first anniversary of the credit crisis. Since then, investors had experienced much volatility in the intervening months. For new investors, such see-sawing can be very bewildering. For even the seasoned traders/investors, the current bear market is in a sense worse than the infamous 1987 crash. In 1987, the crash was done over with in one big hit. After that, life carried on. But for today, the financial pain is slow and grinding- some even call it the water-torture bear market.

In such a time, investors have to be aware of a very common mental pitfall that is common to all human- the narrative fallacy. As we said before in Mental pitfall: Narrative Fallacy:

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.

It is this natural human weakness that accentuates the confusion in such a time of market volatility. If you follow the financial media very closely, you will find plenty of narratives to ‘explain’ what is happening. In fact, some of these narratives are contradictory, as the example in our earlier article in November 2006- How much should we listen to the financial media?.

Right now, we are experiencing falling commodity prices (mainly base metals, oil, gold and silver. The most common narrative explaining this outcome is the “fear of a slowing world economy.” But is there an alternative narrative? We found one in this news article, Falling into line. In that story, falling copper price was the result of a deliberate Chinese squeezing of hedge funds. Hedge funds were reportedly squeezed in the oil market too.

So, which narrative is the correct explanation for falling commodity prices?

Well, the fact that one asks such a question shows that one has fallen into the trap of narrative fallacy. Narrative fallacy demands that the reason be found. But in reality, the reason is nothing more than a reason. Sometimes, a number of these reasons can be more dominant than the others. Other times, no dominance may emerge. In other words, short-term price phenomena can have no specific reasons. But you should not confuse no specific reasons for no reason. Some people say that market prices fluctuate randomly. Personally, we do not like using the term “random” because it conveys the idea that market prices move with without (no) reason.

Having understood this, take a read at this news article: Gold rebounds from sharp sell-off

Gold rose for the first time this month on speculation a 12% decline since the end of July that had erased this year’s gains was exaggerated. Silver rose.

Well, the news media are in the business of selling the narratives.

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