Not only are stories useful for selling investment ideas, they also play another role, as Shiller observes:

People also appear to want to construct simple reasons for their decisions, as if they feel the need to justify those decisions in simple terms – if not to others then to themselves. The need to have a simple reason to explain a decision is similar to the need to have a story behind a decision.

Powerful stories focus the attention of investors on information that can affect the confidence of individual investors and therefore eventually affect the sentiment of the market as a whole. In many cases, these stories involve illogical reasoning, known as the post-hoc-ergo-propter-hoc (Latin for “after this, therefore on account of this”) fallacy.

For example, we might read a news story attributing a 2-per-cent fall in the S&P ASX 200 due to concerns over slowing economic growth in China. Although the two events might be consecutive, we cannot simply assume that the one would not have occurred without the other. The fall in the S&P ASX 200 may have happened anyway. The two events might both be linked by a common factor that isn’t covered by the news story. While it seems likely that both events are related, we cannot be certain that it wasn’t merely a coincidence.

Unfortunately, it doesn’t really matter if a news story is logical or not. Attaching a story to a large price move makes the news story more interesting. It also increases the salience of price moves in the minds of investors and focuses their attention on the ostensible causes for the price moves.

Obviously, all of this has an effect on confidence. These stories also give investors the so-called reasons they need to back up or explain to others why they are optimistic or pessimistic about something. Which stories have the biggest impact on investor confidence and market sentiment?

Price movements
Interestingly, investors seem to pay the most attention to stories about price movements themselves. An example of this is the research by Shiller. Following the 1987 stock market crash, Shiller decided to measure the impact of news on market sentiment by surveying institutional and individual investors. Participants were sent copies of the major news stories published in the days preceding the crash. They were asked to rate the importance of each story in their evaluation of the market, with a rating of one being completely unimportant, four moderately important and seven very important.

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