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Causality v. Correlation; What does this have to do with investing? September 4, 2008

Posted by shaferfinancial in Uncategorized.
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When I was teaching statistics to university undergraduates, one of the hardest concepts for students to operationalize was “causality versus correlation.”  Our senses work against us in this matter.  We see something that follows something else on a regular basis and we assume they are correlated.  In other words “A” occurs before “B” so we assume “A” caused “B.”  But did it?  There are several other explanations; A third factor is actually causing “A” and “B”,  “B” may actually be causing “A” at the same time (a self reinforcing relationship), or the relationship is so complex that there are a host of intervening factors causing the relationship.

Let me demonstrate an example of this that is familiar to my regular readers.  It is a known phenomenon that when the market has prolonged downturns that there are large outflows from the market.  We are now seeing that in the mutual fund market for example.  Wall Street gives us one explanation.  They say, “people don’t have the proper discipline to ignore market downturns, like they should.”  So financial planners all over the country shake their finger at folks and tell them to keep investing, even in down times, and never pull out of the market.”  Now, I am sure they are correct some folks pull out of the market when they see losses.  But, is that really what is going on?  They say “A” (market downturns) causes “B” (people panicking and pulling money out of mutual funds). 

Here is a alternative explanation.  The majority of mutual fund purchases happen inside company 401Ks.  What causes market downturns is ultimately businesses not doing well.  When businesses don’t do well they lay people off, cut back on salaries, and sometimes fail.  So my alternative explanation is businesses start doing poorly causing layoffs and downward salary pressure, which then causes folks to have to use their reserves (401Ks) to support themselves while they look for another job or stop putting money into a 401K to cover for increasing expenses and stagnant or lowering salaries.  So it is not so much people panicking but people using up their reserves in times of trouble.  The declining market is only correlated with the process, not causing the outflows. 

Of course that explanation, has much deeper ramifications for the mutual fund industry than their “people act poorly” explanation.  Because if my explanation is right, then one needs to question the total save/invest monthly in mutual funds inside 401K/IRA for 35 years/become automatically wealthy  paradigm.

But then again that is what I have been doing for awhile now! 

Understanding a little statistics is helpful, not required, to begin to understand that if you don’t have that million dollar 401K/IRA yet, it might not be your poor saving behavior, nor your poor behavior managing mutual funds, but might just be that strategy the financial planning industry has told you will get you to a comfortable retirement.  It won’t, and the sooner you understand that, the better off you will be.

Call me at 727.804.9271 or go to www.shaferwealthacademy.com and fill out the contact form if this fact is starting to dawn on you. Don’t let Wall Street bury your retirement!

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