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The Umbrellas Made It Rain3 min read

How Misunderstanding Correlation & Causation Screws Up Our Intuition

Apr 18, 2018 - John Osbon ( 4 mins to read)

John Osbon

Can a candidate buy an election? Or can a super PAC make the purchase for him? With mid-term elections on the horizon, the effect of campaign spending on election outcomes will be big news again. It makes me wonder if running for office is a voting process or simply an auction. Does spending by candidates and PACs actually predict success? And what does this have to do with investing? Here’s what I’ve learned.

Can money buy elections?

Imagine five to ten million dollar super PAC contributions by individuals right before a primary contest! It’s legal, but isn’t that an unfair, even immoral, advantage? “A big fat no,” according to Stephen Dubner and Steven Levitt of Freakanomics.  I suggest clicking on the link to hear their reasoning directly.  In a nutshell, they argue that yes, the candidate with the most financial support often wins, but the money itself doesn’t generate many votes.

Instead, their research shows it is more the other way around – candidates who have successes attract donations because contributors want to back a candidate who can win. That is, voter support triggers contributions; but contributions and the ad spending that follow do not produce much additional voter support.

This is a great example that differentiates correlation and causation. Just because you see lots of umbrellas on rainy days does not mean the umbrellas cause the rain. While commentators may rant about the unfair influence of big contributions, the Freakanomists say all that money is not buying much additional support at the polls.

Correlation, not causation

Just as candidates running behind in the polls may blame their failures on fat cat donations to opponent super PACs, we often see the same foggy reasoning in investing. The misunderstanding of correlation and causation screws up our intuition. Market pundits and analysts make a living by trying to convince us that Situation A caused stock prices to go up, or that Situation B caused bond prices to go down. These things may sometimes happen together, like a rising stock market when GDP grows, but it doesn’t mean that one caused the other.

I hear and see the “Blame the umbrellas!” effect almost every day in the Wall Street and research community, and certainly in the media, While their arguments may sound sensible (Sell Treasuries!, the Fed is raising rates!), the consequences can be awful. Ask Bill Gross, Jeff Gundlach or Dan Fuss.

As Warren Buffett has often said, “just because you know what the economy is doing doesn’t tell you what stock prices are.” November 2007 was a very rosy economic time, with earnings, stock prices, and the economy all hitting record highs.  We know what happened next.  Similarly, in February 2009 the opposite was true.  The former was a time to sell stocks, and the latter a time to buy, although I can count on one hand the number of people I know who actually did that. Everyone else saw causal relationships that weren’t there and paid a big price. It’s now 2018 and I still hear predictions of imminent investment doom.

The alternative

Plan, instead of guessing, is our advice at Osbon Capital.  Pay attention to facts (current prices and yields) and things you can control (expenses, diversification), and stay focused on your personal investment goals. In that way, you can ignore a lot of useless information and enjoy a portfolio that is built for you.

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