Human bias and market imperfections

I have always been intrigued by the impact of human biases on markets. My inquisitiveness led me to the book Narrative Economics by Robert J Shiller in 2021. It is no surprise that the theory of Narrative Economics is still relevant and more evident these days than ever before. In this short article, I will reflect on the human biases in today’s geopolitical environment and how that is leading to various market imperfections and reactions.

What is Narrative Economics?

Before we dive into today’s evidence of narrative economics, here is a quick summary of the concept. Simply put, Narrative Economics analyses narratives, stories, contagion, etc from an economics and financial lens i.e. how are the stories, going around in the market, are impacting the reactions of investors and policy makers. Robert J Shiller says that contagion is at the heart of narrative economics. Contagion in this context is the pace and quantum of the story spreading across the world which determines the intensity of the reaction that narrative / story will have on the markets and policies. If you are keen to read more about Narrative Economics, then read my article from 2021 here: Narrative Economics: Meaning and Traces in the World Today – Blogs on Markets

Now that we have a baseline understanding of Narrative Economics, let’s put it to use and find evidence in the world today.

Narratives running the markets today

AI

This is the most prominent and obvious narrative in the market. AI and ML were known concepts in the tech world and almost used interchangeably. However, when ChatGPT was launched in November 2022, AI was accessible by everyone. By the end of 2023, AI was perceived like a game changer, a tool that will eat up all the jobs and boost productivity exponentially. That led to tech valuations booming globally. However, in 2026, the story has shifted from simply businesses investing into AI to businesses that are proving the productivity boost using AI. That is clearly seek in tech valuations.

Wars

Wars have been pivotal since 2022 Russia-Ukraine war in making policy decisions. While this can’t be classed 100% in narrative economics, wars are still man-made so that’s the angle I am using here. During the Russia-Ukraine war, good supplies got disrupted globally leading to fears of shortage impacting inflation and the uncertainty around when the war would end led policy makers across the world increase interest rates to curb inflation. While there was a true disruption in food supply, the key to note is the way markets reacted. Markets were not purely reacting to the actual implication of the war. Instead they were reacting to the narrative of fear which exacerbates the overall impact. Similarly, the ongoing war and the closure of Strait of Hormuz created a similar impact where stock markets particularly were reacting on fears more than actual logical impact of the war.

Climate change

This one is very interesting! Pre-pandemic, climate change was the contagion. Anything renewable or related to climate would witness big swings. However, with the pandemic and then wars, climate change narrative seems to have been overshadowed. Lately though it is gaining momentum with temperatures rising to unseen levels this summer and increased number of natural calamities across the world. I wouldn’t call this a contagion yet but this is still an important narrative that can swing the market.

Final thoughts

These are very common narratives. However, what is intriguing for me is how narratives have remained the core of market movements from historical periods to even today. While it is not always obvious on the amount of reaction a story would have or when a story has become contagion, with the advent of technology, it will get easier to mathematicise this concept and use it in making trading decisions more formally. While retail investors would still have to rely on research produced by institutions and have less say in the market, they can at least start making sense of the story the numbers are saying about the market sentiment. This is also why Volume Spread Analysis resonates so much with me. It essentially tries to understand the story smart money is believing and banking on, and tries to follow it as a retail investor. When finance becomes more story-telling than just numbers, I guess it becomes all the more interesting!

Disclaimer: this is purely educational article sharing my personal opinions.