One of the most common problems in economics and finance is the fallacy of composition. The fallacy of composition occurs when you fail to understand the entirety of an argument. As an example, a common fallacy of composition in finance includes the cash on the sidelines myth. The cash on the sidelines myth is the myth often repeated on financial TV regarding the “cash” on the sidelines that will come into the market and drive prices higher. This fails to look at the buying/selling process in its entirety. For every buyer of stocks there is a seller of stocks. When someone “puts cash to work” in the stock market someone else “puts stocks out of work”. It is a clean asset exchange and the change in price is contingent not on how much cash is in existence but the eagerness of the buyer and seller to agree on a particular price. This is just one example of many that exist in the world of finance and economics.
The fallacy of composition is common in many other facets of ours lives. In fact, one could argue that this entire election season was a fallacy of composition. It is the result of many small echo chambers reinforcing the beliefs that we want to believe. Social media and even traditional media have become echo chambers that people tune into to hear what they want to hear. We curate these media outlets to our needs and they feed us exactly what we want to hear. Facebook, for instance, is an echo chamber that profits from your confirmation bias. It allows you to create a feed with people you enjoy listening to. And Facebook doubles down on this curation by creating an algorithmically driven news and advertising feed that is geared towards your particular tastes. You aren’t getting informed or connected from this. You are getting force-fed exactly what you want to hear.
This is highly problematic in the information age as we’re curating news feeds that don’t inform us, but just confirm what we think we already know. In other words, these news feeds create the risk of a fallacy of composition where we fail to fully understand world events because we aren’t digesting the whole story. This has fascinating implications in information theory and especially in ideas like the efficient market hypothesis as the accumulation of more information should not result in greater misinformation. But that is precisely what we’re seeing. There’s a Nobel Prize out there for someone who can help us better understand this and resolve it.
How can one overcome this? Well, the simple answer is to get out more. Get out and meet real people and stop looking at human beings as “user names” in internet forums. Equally important is the construction and curation of our news sources. As a market practitioner I’ve always curated a balanced social media feed. I don’t care about your politics. I care about the direction of prices. And no matter how wrong someone is about the fundamentals of a financial asset it is often belief that drives price directionality. For instance, I largely reject the idea that anyone should own gold based on my fundamental understanding of the asset, but so long as other investors believe gold is a viable asset for various reasons then my personal view is irrelevant if I want to understand price directionality. Financial market participants cannot afford to be biased. As a result I’ve always obtained my news from many news sources. In fact, I almost prefer getting my news from websites and sources that I disagree with. When combined with reading sources I agree with I obtain a fuller view of the overall picture. I suspect that one of the reasons I predicted the Trump win last year was because I saw the groundswell of support from the many sources I read. I wasn’t as susceptible to the fallacy of composition because my chamber of news didn’t echo as much as many other people’s.
So, as uncomfortable as it might be, the big lesson from this election is not that we’re separated or divided. The lesson is that we’re failing to understand the full composition of the world we live in because we’ve created echo chambers that curate the things we want to hear and reinforce our confirmation bias. If we want to solve that problem we need to learn to be more open-minded and give credence to views that we disagree with. We need to make an effort to obtain our information from a broader set of sources. This will better allow us to understand the world we live in and work together to appreciate the needs and concerns of everyone in it.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.