Escaping the echo chamber
A lot has been said about echo chambers and how social media platforms like Facebook or Twitter suck us into them by predominantly showing us new information that confirms our previously held beliefs.
However, the path into an echo chamber depends not only on the algorithms of these platforms, but also on the users’ ability to ignore information that isn’t readily available. We all know that there is way too much information out there, and we all know that we have to make a selection of what to process and what to ignore. The media pushes some information and ignores other. Of course, the selection of the media isn’t unbiased. “If it bleeds it leads” is an old adage from the days when newspapers ruled the world. And, in fact, we rarely read a headline that says: “Stock market up by 0.5% today”. But let the stock market drop by 5% or rally by 5% on any given day and you can be sure to see major articles about the reason for this exceptional performance.
As analysts struggle to come up for an explanation of daily market moves (because, frankly, there typically isn’t an explanation), investors are focusing on a story that seems to make sense to them. These stories become the seed of a new echo chamber and in the next days and weeks a media narrative develops that reinforces this story. Over time, more and more investors start to evaluate markets in the light of this market narrative.
We do know that there is other information out there that may explain market moves better than our dominant market narrative, but these competing narratives are increasingly shut out of sight, because they are not reported in the media and not discussed amongst investors. At the moment, everything in markets is viewed through the lens of Covid-19, so much so that stock markets react more to a perceived decline in fatalities than to fundamental drivers of market valuations. Yes, there has been unprecedented monetary and fiscal stimulus released by governments and central banks, yet, this stimulus has been largely ineffective in a market that only looks at the spread of the virus.
In 2009, a smaller rescue package than the stimulus today was able to turn markets around and start a decade-long rally. Quantitative easing was able to stabilize markets in the aftermath of the financial crisis but has proven completely ineffective this spring.
But there is a way to escape these echo chambers and Benjamin Enke from Harvard has shown what it takes to break a narrative. He subjected volunteers to a series of lab experiments. In each experiment, they were told that a computer would randomly select a series of numbers from the set of the following six numbers: (50, 70, 90, 110, 130, 150). Since the average of these six numbers is 100, participants were shown the first number randomly drawn by the computer and then asked to guess if the average of the randomly selected numbers was above or below 100. After their initial guess, they were shown a selection of the random numbers drawn by the computer.
Let’s assume the participants saw the number 110 and then guessed that the overall average would be above 100. These participants were then shown a selection of numbers that all confirmed their view that the average was above 100. They knew there were additional numbers that they could not see and that could be either above or below 100. Meanwhile, a control group was shown the same numbers that confirmed their original estimate, but also a random selection of the numbers not shown to the other participants. Hence, the control group saw some information that potentially contradicted their view.
Estimation errors of the average of a random set of numbers relative to a rational and a biased person
Source: Enke (2020).
As the chart above shows, the estimation errors of participants relative to a rational guess and a guess that is based only on the numbers shown to them (thus ignoring all the numbers the participants did not see) were vastly different. The participants who were caught in the echo chamber and only saw a selection of number confirming their views believed reality to be similar to the numbers they saw. Meanwhile, the control group that saw a little bit of neutral information was much more accurate in guessing the true average and behaved much more rational.
This shows that exposing yourself to information that contradicts your views not makes you more rational in your decision-making process and – when it comes to investments – gives you an edge to see mispricings in markets that are triggered by one-sided market narratives. I have written about my consumption of media from both sides of the political spectrum and the benefits of this practice in dealing with political and geopolitical events, but this experiment shows that de-biasing your information consumption can lead to a potential investment edge as well.