This year narratives are making a big comeback. Amidst volatility in numbers and an uncertain future, stories soothe investors. These often work at a macro level and for individual shares, but it is with portfolios that stories are at their most inventive. Overall, combining analysis with stories can be helpful. Research shows they can drive economic events, both in individual and collective economic behaviour. But can they cause harm? How can investors sort the useful narratives from fantasy?
Useful stories tend to centre on the economy and markets, often helping investors through turbulent times or highlighting prevailing sentiment. Stories can reinforce understanding and support investors in sticking to their asset allocation amidst volatility. Cutting out some of the noise should help investors to avoid being sucked into every short term rally. The recent July low in sentiment coincided with headlines like “peak pessimism”. All news looked like bad news, yet much investor positioning was already defensive. There are now good tools to assess market mood online that allow some measurement of the prevailing narrative. Even without specialist software, headlines in the financial press and updates from fund managers give a good guide.
Price trends do themselves drive much of the narrative, creating self-perpetuating loops of pessimism or optimism. And often, for simplicity, scenarios are compressed into a shorthand, such as “looks like a re-run of the 1970s”. Unfortunately, once these take hold they can become firmly rooted in investor beliefs and not easily shifted by conflicting data. The human drive for pattern recognition and stories to make sense of a challenging world can mislead. Investors can use stories to manage their risks and asset allocation, but they should scan the environment for any build-up of contrary evidence.
Where stories are really flourishing this year is in portfolio updates and company research. Funds involved in private equity seem to be the most interesting source of wishful reporting. Most stocks that floated over the past couple of years saw their value slashed more than six months’ ago. The market re-prices listed shares quickly, provided that some transactions take place. But private companies such as Klarna and Starling went through a prolonged period of suspended disbelief, remaining at high valuations in portfolios even as their listed peers recognised the new reality. Managers even used different valuations for the same stock in various portfolios they ran, presumably with different stories. Now as private equity valuations begin to be cut, the summer rally is highlighted as a beacon of hope. These sort of stories are not useful.
Investors with memories going back to 2000 will recall the false rallies and bizarre narratives that accompanied the inexorable slide to collapse of many dotcom darlings. Typically it is only in hindsight that the conflicts in terms of fees are revealed. It is challenging to create a robust independent valuation process when incentives and personalities create biases. Previously, too much comfort was taken by ever-increasing pricing as successive financing rounds bought in. That valuation approach now needs replaced with independent process that recognises the potential for a cash flow crisis in some private businesses and the likelihood of material dilution. The discounts on investment companies holding unquoteds point to market scepticism on valuation - particularly when there are no share buybacks at those distressed prices. Instead, liquidity seems to be needed to support lossmaking investee companies.
Behavioural economics provides good explanations for the attachment that many investors feel towards their portfolios and favourite stocks. Research shows stories reinforce this, with emotion creating a false sense of value. Indeed, prices of some technology stocks may have been inflated by unrealistic narratives even before this year’s sell-off. That attachment is now a barrier to price discovery – at this stage, investors deserve more independence and candour rather than stories.
A version of this article was published in Citywire on 30.8.2022.