Posts Tagged ‘narrative fallacy’

Is it time to buy stocks in times of intense fear and volatility? Part 3: Stock picking approaches

Wednesday, October 29th, 2008

Today, we will continue from Is it time to buy stocks in times of intense fear and volatility? Part 2: Leverage position,

What if you are one of these contrarian investors seeking to increase your risk in the stock market? Which stocks to pick?

Broadly speaking, there are two approaches to stock-picking: (1) top-down and (2) bottom-up.

The bottom-up approach is, as we explained in Confidence back? Beware of bear market rally,

… invest in businesses based mainly on its individual merits and not worry about the macroeconomic big picture, the business cycle, e.t.c. … In that sense, such value investors are neither ?bullish? or ?bearish.? Rather, they have a neutral view on the business cycle and other macroeconomic big-picture.

The last few articles of our guide, Value investing for dummies, will elaborate more on the basics of the bottom-up approach. If you want to utilise the bottom-up approach, please understand that it has a major weak point, as we explained in Should value investors be ?bullish? in a bear market?:

But this is where the Achilles? heel of value-oriented stock research lies. Because they hold a neutral view on the macroeconomic big picture and business cycle, they can severely underestimate the effects of a protracted downturn in the earnings of businesses.

The top-down approach is to start off by looking at the broad macroeconomic themes and then zoom into individual businesses that may benefit from those themes. An example of such approach is to look at the broad macroeconomic implications of rising long-term energy prices (see How to profit from rising energy prices?) and then study the merits of investing in oil companies and alternative energy developers.

This approach has intuitive appeal because of human tendency to seek out a story. Macroeconomic themes are always expressed in the form of stories. But you must be aware that due to your human weaknesses, the appeal of stories can cause you to fall into narrative fallacies (see Mental pitfall: Narrative Fallacy). In addition, a superficial understanding of stories tend to lead one to oversimplify the thought process of picking stocks based on macroeconomic themes. For example, just because commodity prices is in a very long-run secular up-trend does not mean that any mining stocks will be good long-term investments (see Rising metals price=rising mining profits? Think again!)- there are much more subtleties involved.

In the next article, we will talk about the bottom-up approach by continuing on the incomplete series at Value investing for dummies.

Fooled by narrative fallacy

Monday, August 18th, 2008

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.