The distinction between correlation and causation can help institutional investors determine better factors for investment decisions, according to Steve Foerster, a finance professor at Western University.
Speaking during the Canadian Investment Review’s 2024 Investment Innovation Conference, he said a confusion between the two terms and their part in investment stories is impactful. “When it comes to factor models, be skeptical. Look for whether there might be spurious correlations. Look for whether there’s a plausible causation story.”
In his new book, Trailblazers, Heroes and Crooks: Stories to Make You a Smarter Investor, Foerster shared the story of how soccer star Cristiano Ronaldo removing a bottle of Coca-Cola from a podium in a press conference is remembered as the cause of a stock market valuation tumble for the beverage manufacturer.
“Was there a correlation between Ronaldo moving those Coke bottles and on that day Coca-Cola losing US$4 billion? Absolutely there was a correlation. Was there causation? Absolutely not.”
Indeed, the Coca-Cola example adds to Foerster’s theory about distinguishing between correlation and causation because Ronaldo’s diss didn’t directly impact the valuation of the company. In fact, on the same day of trading, the company performed even better. Just because there’s a plausible explanation, he said, there’s no guarantee it will relate to future performance.
“We could perhaps infer that in the days and perhaps a week or so following the snub, there may have been a temporary effect, but certainly by the end of six weeks, we’re back in positive territory.”
Its vital for investors, including pension plan sponsors, to have a set of investment beliefs and principles that guide their decision-making, he said, noting he has primarily been a passive investor after a hard-learned lesson in active investment.
Read: Expert panel: What are some CEO red flags for institutional investors to consider?
“This stock had done really, really well in its first year after the initial public offering. [For] the first and only time, I bought long-dated, two-year put options because I was convinced, based on my own research, that these IPOs tend to be overvalued. That stock was Google [now Alphabet Inc.] and I lost all of my investment.”
Referring to updating investment beliefs, Foerster noted any changes to the core thesis needs a basis in evidence without any emotion attached to the rationale. “We have our behavioural biases and they can hurt us. They can hurt our investment performance. Overconfidence is a huge one, which often leads to excess trading. We often look at things through rose coloured glasses and we see what we want to see.”
Read more coverage of the 2024 Investment Innovation Conference.