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Tangled up with blue - Beware plausibly worded correlations that have no causal link

05/06/2014

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Should any visitors to the value perspective be considering a new career as a civil engineer, we have just one piece of advice – make sure you are eating enough mozzarella. we are a bit hazy on the exact science – presumably mozzarella contains a specific protein that has a particularly beneficial impact on the civil engineering-friendly part of our brains – but how could anyone doubt the following evidence?

sources: usda and national science foundation tylervigen.com may 2014

As you can plainly see, the above chart plots two lines – the rise in per capita consumption of mozzarella in the us over the first 10 years of this century and the increase in the number of civil engineering doctorates awarded in the country over the same period – that have around a 95% correlation (http://www.schroders.com/tvp/glossary). however, we need to be very careful here and i think we all know why.

It is of course because if, in your haste to become a civil-engineering prodigy, you eat the wrong sort of cheese, the results could be hazardous to your health. again we are not entirely sure about the precise scientific details – beyond the well-known fact cheese can give you night terrors – but here is the terrifying evidence that cheese can be quite literally deadly.

sources: usda and cdc tlyervigen.com may 2014

It is almost unbelievable, we grant you, but once again the correlation between the above chart’s two lines – the per capita consumption of cheese in the us over the first 10 years of this century and the numbers of people who have died after becoming entangled in their bed sheets over the same period – is around 95%. Seriously – how statistically significant is that?

That of course is the crucial question – and the crucial answer is that no correlation has any statistical significance without a causal link. Clearly there is zero causation with either of the above correlations and, as we did not try and dress them up in lots of plausible technical jargon – the dangers of which we highlighted in The means of seduction – you presumably worked that out pretty quickly.

The thing is, as we have noted before in articles such as Killer question and Invest in rhyme, confusing correlation with causation is a trap investors fall into time and again. What is more, there are currently a number of investment strategies on the market that have been back-tested over shorter periods of time and demonstrated lower correlations than our cheese-based examples.

While people may be happy to entrust their money into such options regardless of the lack of causation, we prefer to recommend strategies that can not only demonstrate outperformance but are also able to explain why they outperform. This understanding is the only protection from being whipsawed by the short-term underperformance that will inevitably affect all strategies at some point.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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