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The small detail behind big stock market returns

Apr 30, 2015

In this issue:
» Is India losing its most favoured emerging market tag?
» Smart cities plan to get a big boost
» A round up on markets
» ...and more!


00:00
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 rationalise 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.

Do you focus on right causal factors while investing? Let us know your comments or share your views in the Equitymaster Club.

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03:30
  Chart of the day
India has for long been the most favoured emerging market for foreign investors. However, it seems that it is at the risk of losing the tag soon. As seen in today's chart, foreign inflows for the month of April have been just US$ 1.8bn, much lower when compared to other peers.

Uncertainty regarding the government's stance on retrospective taxation on capital gains of the past has made foreign investors jittery. This coupled with expectations of poor monsoons and weak earnings announcement has impacted the foreign flows for month of April. However, when seen on a year to date basis India still leads other nations in terms of attracting foreign flows. Nonetheless, the margin is thin. Thus, if the government does not resolve the tax issue soon or if earnings fail to materialize, India may well lose its top spot to other emerging nation.

Will India lose its most favoured emerging market tag?
MTD= Month to Date; YTD=Year to Date

04:05
Those of you who had attended The Equitymaster Conference of 2015 may recall that we had explained how the 100 smart cities project was a key to realize India's urbanization dream. It seems that this was not a pipe dream sold by the Modi government but may soon become a reality.

The Union Cabinet has approved Rs 1 trillion urbanization plan that has proposed to create 100 smart cities over the next 5 years. Such cities will have complete basic infrastructure in place including water supply, sanitation, public transport etc. The government will give assistance of Rs 1 bn each year for making smart cities. State government and local bodies including the private sector are also expected to contribute to this mission. Once executed, this shall increase urbanization rate and employment opportunities to a great extent. Further, sectors like housing, construction, cement, paints etc will be the biggest beneficiaries thereby providing a necessary boost to India's economic growth.

04:30
The Indian stock markets were trading in the red at the time of writing. While the BSE Sensex was down by 216 points, NSE-Nifty was down by 59 points. Most Asian markets were trading mixed at the time of writing. European stock markets also opened in the red today.

04:50
 Today's investing mantra
"I don't read economic forecasts. I don't read the funny papers" - Warren Buffett

Editor's Note: Please note there will be no issue of The 5 Minute Wrap on Friday and Saturday on account of market holidays.

This edition of The 5 Minute WrapUp is authored by Jinesh Joshi and Rahul Shah.

Today's Premium Edition.

Should you invest in the 'smart cities' theme?

The green signal for the 'smart cities' project will be a game changer for the economy.
Read On...Get Access

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4 Responses to "The small detail behind big stock market returns"

shivkumar

May 12, 2015

The most confused fellows are the one who coming as experts in TV media advising investors about the stock market movement.
They will say lot of jargon and try to explain the movement of stock prize. But the poor investor who put money will have no much clue e what it is going to happen.

Like 

KD

May 2, 2015

Excellent article. In news we always hear stocks went down because ....

Like 

RS Rathore

May 1, 2015

To me, your 5-Minute Wrapup of 30th April'15 seems one of the best editions I have ever received. As per you, making up of mind for long term investing is a better option and I fully agree with you. I believe, this option should prove beneficial to me in the long run.

Like 

DrHA!

May 1, 2015

The present government can say that the capital gains tax will be applicable from 1st April 2015 and not retrospectively. Let past be past and the fact that the capital gains was not collected may be due to some parameters not considered by earlier governments. Hope the present government will magnanimously give this concession.

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Equitymaster requests your view! Post a comment on "The small detail behind big stock market returns". Click here!
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