Everybody loves a story – and investors are no exception. But it’s easy to get carried away, says Merryn Somerset Webb, and forget the underlying truth of the market.

One thing stockmarkets are extremely good at is storytelling. Every bubble, every shift in market sentiment, comes with a good yarn. You could even characterise a market as a story competition – the best one gets to provide the framework for the winning investment strategy. 

Look closely at the market, and you will see that whatever people say about stockmarket analysis being driven by models and maths isn’t quite true. We were hearing the story of bitcoin – how cryptocurrencies will save us in an age of government overreach and fiat money meltdown – long before the models comparing its market capitalisation to that of gold appeared to justify a forecast price of $500,000.

The same is true of ESG investing (that which has an eye to environmental, social and governance issues). The story goes that if fund managers would only step up and focus on non-monetary issues we could avoid another financial crisis and all make more money too. The problem with this narrative is that for years it had no real statistical basis – before, that is, the growth bubble gave it some happy numbers to work with, largely because most stocks that fit ESG models are also growth stocks. 

The same is true of the growth boom itself. Stories tend to come before the models that back them up – I think market participants all know this to be true. But turn to Nature magazine and you get a hint of how it might be the case across many professions. The journal cites a recent academic paper studying theories about the connection between consciousness and neural activity (which are more relevant to markets than you might think, by the way). The paper’s authors observe that most studies “interpret their findings post hoc, rather than a priori testing critical predictions of the theories”. In other words: stories come first. 

This is unfortunate in markets (fun, of course, but unfortunate) – because, unconstrained by the absolutism of a models-first environment, we tend to take things to extremes and to extrapolate our stories to the point at which they become nonsensical. And so it has been with the great growth boom over the past decade. 

The story started well, with the recognition that the growth potential in technology in particular was undervalued following the financial crisis of 2008. But it turned into both a belief (neatly backed up by academia) that finding the companies with the best potential for growth is all that matters for long-term investing success, and an unnatural division of the market into growth stocks and value stocks.