Have you ever caught yourself asking, “Shares of company XYZ have moved a lot today. What could have caused it?” I have, and I’m sure many of you do too. But have you considered the possibility that there might be no reason? That fact is hard to accept and that is why we often see news headlines like Asian Stocks Retreat as Higher Oil Damps Optimism which appeared on Bloomberg Business Week on 27 February 2013. The article said that Asian stock markets fell because oil prices are “near a nine-month high and continued concern that Greece…
Have you ever caught yourself asking, “Shares of company XYZ have moved a lot today. What could have caused it?” I have, and I’m sure many of you do too. But have you considered the possibility that there might be no reason?
That fact is hard to accept and that is why we often see news headlines like Asian Stocks Retreat as Higher Oil Damps Optimism which appeared on Bloomberg Business Week on 27 February 2013. The article said that Asian stock markets fell because oil prices are “near a nine-month high and continued concern that Greece will not be able to avoid a default spurred investors to lock in gains.” But, could we have seen a plausible-sounding ‘cause’ when there really is none?
According to behavioural psychology, that headline might just be mistaking correlation for causation.
Our Cause-seeking Brains
Behavioural psychology is a branch of psychology that seeks to explain how our emotions can cause us to perform acts that defy rational thinking. Daniel Kahneman, an authority on behavioural psychology and a Nobel Prize winner, wrote in a book Thinking, fast and slow. Kahneman related how experiments done by psychologists in the 1940s have shown that we are “evidently ready from birth to have impressions of causality, which do not depend on reasoning about patterns of causation”.
One such particular experiment involved people being shown a film of Object 1 moving into Object 2. If Object 2 moved instantly after contact with Object 1, participants would describe Object 2 as being “launched” from Object 1. That is an indication of them seeing the film as a ‘cause-and-effect’ scenario.
This propensity to view events with the lenses of ‘cause-and-effect’ affects us in our daily lives and especially so in the financial markets where the stakes are high.
Now for some Headlines
Two weeks ago on 13 April 2013, a Dow Jones headline read Asian Shares End Higher; Weak 1Q China Growth Boosts Scope For Easing. The Dow Jones article’s saying that the Asian stock markets had rose because of weaker GDP growth from China.
But hold on a second, on 15 April 2013, we had the Citywire Global headline, Asian shares decline as China GDP growth disappoints. The article went on to cite how many of the prominent Asian stock market indices had slipped. You might have thought China’s disappointing GDP growth caused stock markets across Asia to decline.
So who should we listen to and what’s going on here? Due to our need and propensity to have impressions of causality, could we have grabbed at a plausible sounding explanation and saw it as ‘the cause’, when instead it could just be a simple correlation? It might very well be the case that stock markets were doing what stock markets do – they were merely fluctuating.
There was an even more striking example that appeared in Nassim Taleb’s book, The Black Swan. Taleb wrote that on Dec 2003, Saddam Hussein was captured and U.S. Treasuries (which are bonds issued by the US government) rose. In response, Bloomberg had a headline that went U.S TREASURIES RISE; HUSSEIN CAPTURE MAY NOT CURB TERRORISM. Just half an hour later, when Treasuries started falling in prices, there was a new headline on Bloomberg – U.S TREASURIES FALL; HUSSEIN CAPTURE BOOSTS ALLURE OF RISKY ASSETS.
Bloomberg was attributing the rise and fall of US government bonds to the exact same event. How can that be? Kahneman commented that “Hussein’s capture was the major event of the day, and because of the way the automatic search for causes shapes our thinking, that event was destined to be the explanation of whatever happened in the market on that day”.
If we look back to the events of the past few weeks, the slowdown in China’s economic growth was one of the major events and probably was ‘destined’ to be the cause of market movements as well.
Foolish Bottom Line
Sometimes financial market prices do move for legitimate reasons, such as when the share price of a company would rise to the acquisition price that an acquirer is paying or when there’s a significant business development. But more often than not, we might be grasping at straws to find ‘reasons’ for market movements that are the results of normal day-to-day fluctuations.
At the time of writing (3:10pm, 22 April 2013 in Singapore), the Straits Times Index (SGX: ^STI) is up 0.3% to 3304, a movement similar in magnitude to the one cited in the Citywire Global article. But, we’re not seeing any new economic data about Singapore or the rest of the world and yet the index is moving. In short, the economy and financial markets are just too complex for simple causations to explain short-term price movements.
What then can we do in the stock markets when faced with a barrage of information knowing that causal-links are fleeting or non-existent most of the time? Well, we can invest in companies. We can invest with a long-term view of the stock markets knowing that companies become more valuable over time when they deliver higher sales, cash flows, profits and healthier balance sheets, just as how it should be when private business owners evaluate their own businesses.
Don’t be bogged down by false causations for short-term stock market movement. Focus on what’s truly important – the intrinsic value of a business.
Click here now for your FREE subscription to Take Stock Singapore, The Motley Fool’s free investing newsletter. Written by David Kuo , Take Stock Singapore tells you exactly what’s happening in today’s markets, and shows how you can GROW your wealth in the years ahead.
The Motley Fool’s purpose is to help the world invest, better. Like us on Facebook to keep up-to-date with our latest news and articles.
The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Chong Ser Jing doesn’t own shares in any companies mentioned.