Tesla founder Elon Musk is, to me, the ultimate investment Rorschach test. To his supporters, Musk is a genius without equal. As one Wall Street analyst put it, “If Thomas Edison and Henry Ford made a baby, that baby would be called Elon Musk.” But to his detractors, Musk is an erratic individual, the leader of a money-losing company whose bravado has landed him in hot water with the SEC.
This week, Tesla’s stock encapsulated those contrasting views. On Monday and Tuesday, the stock gained 36%. But then on Wednesday it dropped back 17%. To put that in context, on a typical day, the overall stock market moves about 1%.
These extreme movements are an example of what economist Robert Shiller, in his new book, calls “narrative economics”—a story so compelling that it begins to dominate conversation, spread rapidly and take over the headlines. In modern parlance, they go viral.
While Tesla is notable, these kinds of narratives have driven countless booms and busts—from Dutch tulips to the dot-coms to Bitcoin and now Tesla. In each case, the narratives combine a little bit of data with a little bit of imagination to paint a picture that drives investors—or speculators—into a frenzy.
Sometimes narratives come from hucksters and promoters, but sometimes they come from reliable sources, and that can propel them even faster. In 2004, for example, Alan Greenspan, then chairman of the Federal Reserve, made a statement that helped stoke enthusiasm for the housing market. You know how that story ended.
But here’s the problem with stories: They’re not all bad. Stories can help us understand and make sense of the world. In fact, memory experts will tell you that stories help us retain information in a way that is impossible with raw facts and figures. That’s how people accomplish feats like reciting 100,000 digits of pi. So stories do serve a purpose.
As an investor, how can you tell the difference between a narrative that is worth your attention and one that’s likely to lead you astray? Below are five questions to ask:
1. Does it sound too glib? The best stories—the ones that people most like hearing and repeating—are the ones that sound clever and unique. During the dot-com era, people talked about the “new economy” and during the 2008 financial crisis, people talked about the “new normal.” When you hear things like this, it’s a sign you’ll want to dig deeper.
2. What does the data say? If someone is telling you a story, always start by asking for evidence. Then seek out your own data—from unbiased sources. If it’s a financial topic, for example, I recommend the St. Louis Fed or the Congressional Budget Office.
3. What’s the other side of the argument? Tesla’s detractors like to say that the company has never had a profitable year. That’s absolutely true, but what they won’t tell you is that recent quarters have indeed been profitable, suggesting that things might be heading in the right direction. With the Internet, it’s usually not hard to find opposing points of view. Seek them out and use them to form your own judgement.
4. What are the historical analogs? This week, someone asked me how worried to be about coronavirus. My recommendation, as a starting point, was to compare this outbreak to prior ones, such as the Ebola outbreak five years ago. While every story is unique, they usually have a historical analog that is useful for comparison.
5. What if there is no historical analog? On my bookshelf, one volume sits front and center: The Black Swan by Nassim Taleb. In it, Taleb describes how Europeans always assumed that all swans were white—until they traveled to Australia and learned that black swans exist too. The lesson: Just because something hasn’t happened before, or just because you’re not aware of it, doesn’t mean that it can’t happen. There’s a first time for everything. So look for historical analogs—but if you can’t find one, don’t dismiss it. Instead, ask if you might have a black swan on your hands.
That’s my framework for evaluating narratives. But every investment opportunity is, to some extent, a Rorschach test. What should you do if you see something that could be a home run, or could just as easily be a flop? That’s when I employ my thousand-dollar rule. If, early on, you had put just $1,000 into Tesla or Bitcoin, or into Apple before Steve Jobs came back, you’d be sitting on a fortune today, even if you had also wagered $1,000 on some duds. If the fear of missing out is too strong to suppress, that is my recommendation. Risk just a small amount, view it like a lottery ticket, definitely don’t buy too many, and hope for the best.