The Power of Narratives: How Stories Shape Investor Behavior

The art of storytelling has been the foundation of civilization since the earliest days of human communication. Stories bridge cultural divides, spanning time and distance, and have the power to both entertain and educate. As stock selectors, our investment decisions are partly influenced by fundamental data—but when communicating these stock prospects, we tend to present them as a narrative, thereby indistinctly merging the lines between hard data and the story we create.

As these narratives are disseminated from individual to individual, the truth becomes obscured. As it moves into the public domain of common knowledge, influencing behavior, it has the potential to be manipulated by those in a position of power—what we call the missionary.

What the hell is narrative?

The narrative is simply the way we tell each other stories and forms the water in which we navigate market behavior. For most of our existence, we have lacked the tools to measure it nor did we realize that it even existed despite its omnipresence.

In the investment world, narratives are constantly on display in social media, podcasts, investment blogs (Reddit, Seeking Alpha, etc.), and 24-hour news feeds. This noise can be deafening and overwhelming as one tries to connect the dots. However, what we think about the "news" is irrelevant. What we want to know is what everyone thinks about what everyone thinks about the "news."

The narrative landscape is game theory at the highest level, akin to playing poker. Poker is part science—the odds your cards are the best—and part art: reading your opponents and their actions to gain insights on the cards they may hold. Understanding the narrative is similar. The science is how it groups articles that are similar in topic and language. The art is reading the data and understanding how the market players will react to the narrative.

Measuring the Narrative

Technological advancements in processing speed and the ease with which data is disseminated have enabled the development of tools to capture and analyze the language in data. We use NetBase Quid, a natural language processing program (NLP) that allows us to upload articles to analyze and visualize the narrative in a map-like image known as a neural network map. Through this visualization, we can look for behavioral biases that have led to potential mispricing in the market.

One example: during the second quarter of 2020, our analysis of market and economy articles showed that inflation was appearing as a fringe but connected topic—disconnected from the central narrative, but present. By late 2020, inflation had become a central theme. Our conclusion was that inflation was not "transitory" as Fed Chair Jerome Powell stated. This key insight turned out to be impactful as we adjusted our portfolio to capture the inflation and looming rate rises already embedded in the economy.

The key: all the CEOs and CFOs knew inflation was hurting their margins—and this gave them the cover to raise prices, ultimately pushing inflation higher. The narrative of inflation in early 2021 played out over 18 months through 2022.

The Art and Science

Keynes had it mostly right: the narrative can remain irrational longer than you can remain solvent. The hardest part of analyzing the narrative is patience. The key is that we have to analyze the press releases, the news, and the commentary and then react.

Understanding the narrative is part science and part art. The science is the grouping of words and sentences into common themes and visualizing the sentiment of those themes. The art is understanding how the market players will react to those themes. The art of storytelling is also evolving—with new technologies blurring the lines even more between reality and imagination. It is imperative to have a process to navigate these waters.

The real challenge lies not in the story itself, but in the power of humans to transform tales into influential narratives that shape behavior and trigger market disruptions. As portfolio managers, our role is to navigate these pitfalls and identify investment opportunities—or potential risks—based on rigorous analysis.

Like the reporter said to Jimmy Stewart in the 1962 western The Man Who Shot Liberty Valance: "When the legend becomes fact, print the legend."