Narrative Fallacy: How Stories Impact Decision-Making

One of the limits to our ability to evaluate information objectively is what’s called the narrative fallacy. We love stories and we let our preference for a good story cloud the facts and our ability to make rational decisions. This means that we may be drawn towards a less desirable outcome simply because it has a better story. This is an important concept in behavioral financeBehavioral FinanceBehavioral finance is the study of the influence of psychology on the behavior of investors or financial practitioners. It also includes the subsequent effects on the markets. It focuses on the fact that investors are not always rational.

Why Do We Love Narratives and fall into the Narrative Fallacy?

We are all hard-wired to love stories. Why do we love stories? Typically, stories have emotional content which appeals to our subconscious or reflexive reasoning. Because stories have that emotional component, they’re very easy to remember.

When teachers are lecturing to students, they often use stories. They do this precisely because they know that students can more easily retain and recall information contained in stories.

The narrative fallacy stems from this innate love of stories.

Issues with the Narrative Fallacy

The problem with stories is that they may negatively govern the way we think. What’s interesting in the financial markets is that investors often abandon evidence in favor of a good story. This is one of the reasons why people sometimes shy away from value investing, which forces investors to look at stocks that may not have the best stories. In fact, they often have horrible stories. The most admired stocks have the greatest stories, but they also tend to have the highest prices.

Stockbrokers have taken advantage of the narrative fallacy for years, convincing clients to invest in a stock by telling them a great story about the company.

So, are you being limited in your learning by falling into the narrative fallacy? Label stories as such, set them to the side, and try to focus solely on the facts.

Additional Resources

Thank you for reading CFI’s explanation of the narrative fallacy and why it’s important to be aware of it in finance. To learn more, check out CFI’s Behavioral Finance Course.

Additional helpful resources include:

• Behavioral Finance GlossaryBehavioral Finance GlossaryThis behavioral finance glossary includes Anchoring bias, Confirmation bias, Framing bias, Herding bias, Hindsight bias, Illusion of control
• What is Financial ModelingWhat is Financial ModelingFinancial modeling is performed in Excel to forecast a company's financial performance. Overview of what is financial modeling, how & why to build a model.
• Framing BiasFraming BiasFraming bias occurs when people make a decision based on the way the information is presented, as opposed to just on the facts themselves. The same facts presented in two different ways can lead to different judgments or decisions from people.
• Self Serving BiasSelf Serving BiasA self serving bias is a tendency in behavioral finance to attribute good outcomes to our skill and bad outcomes to sheer luck.  Put another way, we chose how to attribute the cause of an outcome based on what makes us look best.