Coincidences, Corelations, investing!!!

I am sure all of us fondly remember the time when we got hiccups as kids and then being told by our grannies it`s a sign that someone is remembering us. Or the time when crows caw-cawed at the top of their voices in our balconies. For many, it was a signal that some close relatives are likely to pay us a visit soon. Of course, as time passed, most of these beliefs have come to be known as nothing but mere superstitions. But wouldn`t it be interesting to find out how did they originate in the first place?

Well, the answer lies in the most gifted yet somewhat eccentric human organ ever created. Our brains that is. You see, our brains try to make sense of the things around us by resorting to causal stories all the time. In other words, if an event A has happened, we find hard to believe that sheer chance or luck caused it. We immediately start to rationalize that some other event B caused event A to happen. Even if it is something as unrelated as our hiccups being caused by someone near and dear remembering us. Our brains just refuse to accept the fact that there are thousands of possibilities out there. And therefore it could just be coincidence that when B happens, A also happens.

Putting it differently, what essentially happens is that we often confuse correlation for causality. And no one has made more fun of this apparent shortfall of our brains than a gentleman who answers to the name of Tyler Vigen. On his eponymous website, there are some really bizarre conclusions that he has arrived at. For e.g. did you know that the more cheese of a particular variety called mozzarella the people of US consume, the more civil engineering doctorates come out of US universities! Or for that matter the more chicken the US eats, the more crude oil it imports.

Well, if you are scratching your heads trying to find out the link between these events that seem so highly interdependent, let us tell you to relax. Please note that no such links exist. It`s just that there`s high correlation between these events but absolutely no evidence of causality. Actually, the wiring in our brains is at fault here. Whenever two variables show some trend of moving together, our brains automatically assume that one causes another. But as Tyler Vigen has shown, this could prove to be ridiculously wrong at times.

Unfortunately, we carry this bias over into the field of investing as well. You see, success in investing is all about trying to predict where stock prices are going to be in the future. And therefore we start to look for factors that have a high degree of causality with them. However, often times we zero in on parameters that have high correlation but are not necessarily the cause of higher stock prices.

What makes matters worse, especially in the short term, is that these high correlation but low causality factors do tend to dictate stock prices.

For e.g. things like interest rates, inflation, currency movements or commodity price movements do end up showing high correlation with stock prices in the near term. But do these cause the stock prices to move in the long term? Absolutely not. Long term, it is things like business fundamentals and the quality of the management that drive stock prices. And therefore, it is these causal factors that investors need to rely on if they need to succeed doing long term investing.

Trust us, what causes most people earn poor returns while investing is the inability to distinguish between these two parameters. And also the difficulty in sticking with the right ones over a long period of time.

So the next time you are attempting investing, ask yourself whether the parameters you are looking at will predict stock prices accurately over the short term or the long term.

If it is the latter, you are on the right path even though you could face some hiccups in the near term. However, if it is the former, you could do well to abandon them even though your near term results are good.