Beware the quick and dirty explanations that tell us nothing
• Ad-hoc interpretations do not really make sense, yet are often swallowed without question
An ad hoc explanation isn’t an explanation. It’s a way of coming up with a story that seems to fit what’s happened, usually without any evidence that it is correct.
Jane is dating Joe, who is very much like her. Jane’s friend explains the pairing by saying “birds of a feather flock together”. When they break up and Jane starts dating someone completely different to her, the explanation is that “opposites attract”. In fact neither is a real explanation of Jane’s motives for dating who she is dating.
Like Jane’s friend, market analysts tend to rely on post-hoc explanations to explain market behaviour. When a stock falls in price for no obvious reason, for example, they’ll happily put it down to profit taking, based on little more than the fact it went up in price before coming down. And while that might not be true, it fits, has a nice ring to it (better to take a profit than a loss, as probably happened) and avoids the speaker having to say, “I don’t know”, which is more likely the truth.
An ad-hoc explanation often exists for no other reason but to save a favoured hypothesis or protect a reputation, making it as useful as no explanation and potentially more dangerous.
So, it’s worth knowing how to spot one.
For a start, they are typically not coherent and have no testable consequences, even though to someone inclined to believe them they look valid.
Question: why did the market do what it did? Answer: we can never hope to know why the market behaves as it does, we can only aspire to understand how.
Another characteristic of an ad-hoc rationalisation is that it often contradicts a basic assumption that was originally accepted, implicitly or explicitly, but is now better abandoned. Question: what happened to the shares? Answer: it was a healthy correction.
Some of the same analysts who say that might have argued a day or two before that the market wasn’t overpriced. So what was “corrected” if not too high prices? No one ever asks.
The giveaway for ad-hoc explanations is that they fail to explain anything, which is what an explanation is supposed to do and why an ad-hoc explanation is defective. Genuine explanations make events more, not less, understandable.
So, why do prices fall? “There are only two possible reasons,” says John Cochrane, a senior fellow of the Hoover Institution at Stanford. “When there is bad news about future profits, or when the discount rate rises.”
The discount rate is the rate investors require, looking forward, to get them to buy stocks. If people require a better rate of return, with no change in their expected cash flows, prices drop until the rate of return matches the other attractions on a riskadjusted basis. Good news about returns is bad news for stock prices. Bad news about cash flows is, well, bad news.
The question investors need to be asking, therefore, when looking for an explanation as to why prices are falling is: is this a moment of bad cash flow news or higher discount rate?
When he went looking for an explanation for the sudden downturn in US markets earlier in February Cochrane came, by way of a lengthy analysis, to the conclusion that “the stories that the recent stock-price decline comes from rising long-term real interest rates make sense. They might be wrong, but they make sense.” He thereby agreed with the Wall Street Journal at the time that “investors may finally be figuring out that the global quantitative-easing monetary party is ending”.
“The question [still] before us,” says Cochrane, “is whether long-term real rates are finally rising — back to something like the historical norm that held for centuries — and if so why?”
The good story is that the US is entering a period of higher growth, probably leading to higher stock returns and bond returns. The bad story is that publicly held debt in the US stands at $20-trillion. At some point, bond markets say no, and real rates go up because the risk premium goes up, possibly leading to stagflation in a tight fiscal moment.
Which is it? “I don’t know,” admits Cochrane.
Barry Ritholtz, writing for Bloomberg, also had a go at debunking after-the-fact explanations given for the market’s unpleasantness in February.
“When blaming the correction on inverse and/or short volatility,” he said, “it’s unfathomable that anyone could believe that we wouldn’t see a return to a more normal trading environment…. The problem with blaming [too high] valuations is that, people have been complaining that markets are overvalued since late 2009.
“Risk parity is an odd thing to blame, since risk-parity funds held up better than most…. Fed tightening can’t really be the cause either, as the Federal Reserve has been especially clear and consistent during the past two years about a gradual return of interest rates to historically normal levels ....
“And while high-frequency trading could make a downturn worse, it isn’t likely to be the underlying cause of the present correction,” he says.
What bothered Ritholtz more than the fact that these explanations didn’t really make sense, was that they were so readily accepted. “One of the more fascinating aspects about people and markets,” he says, “is how uncertain we are about what will happen next, yet so cocksure in our explanations of what just occurred.” The answer can be found in what psychologists describe as the narrative fallacy and hindsight bias.
In short, as a species we like to tell stories — it makes things more memorable — and we believe we have the ability to foretell the future, a power we clearly don’t possess.
We create a screenplay in our heads, with each event leading to the next logical step, until we reach a conclusion and denouement. This oversimplification of reality is blind to nuance, yet sees cause and effect where none exist.
Randomness is a more difficult concept to accept as an underlying driver of events than the more comforting concept of causation.
Hindsight bias takes our storytelling a step further: not only do we create these narratives to help explain what just happened, but after the fact we believe we knew it all along.
Unexpected events, after they occur, seem obvious and predictable, despite there having been little or no objective basis for predicting them. Interestingly, hindsight bias is not only affected by whether or not the outcome is favourable or unfavourable, but also the severity of the negative outcome. This all adds to our willingness to accept ad-hoc explanations.
HOW UNCERTAIN WE ARE ABOUT WHAT WILL HAPPEN NEXT, YET SO COCKSURE IN OUR EXPLANATIONS OF WHAT OCCURRED