Be Cautious Counting on Correlations

Great site pointed out by @reformedbroker over the weekend… looking at ‘spurious correlations’

Here’s a few of our favorites:

Divorce Correlation

Number of people who died by becoming tangled in their Bedsheets
correlation with
Total revenue generated by skiing facilities (US)

= 0.96

Number of people who died falling off a Cliff
correlation with
Number of lawyers in Ohio

= -0.85

These stats would have us believe that the more margarine people eat, the more people get divorced in Maine; that the less people who die getting tangled in their sheets means the lower the national ski industry revenue is, and that every time a person goes off a cliff – there’s one less lawyer in Ohio (maybe it’s the lawyers jumping off the cliffs).

But surely those aren’t the case, and assuming such would be making the classic error of confusing causation with correlation. What’s more, we would argue these things aren’t even really correlated, despite the statistics. We would bet that going back 100 years would show correlations of closer to 0.00 for all of the above, because we know intuitively that margarine consumption and divorce have nothing to do with one another.

Which leads us to the cautionary correlation corollary, which is to be extra careful when trusting correlations, especially ones on annual data with few data points as appears to be the norm on the spurious site. The investment world is filled with classic examples such as stock returns being correlated with women’s skirt lengths; but the real lesson here may be a but more nuanced.

The real lesson for us is twofold – 1. Anything can become correlated over a set period of time. Anything. Just peek back at 2008 for a real world example when stocks and bonds, stocks and gold, stocks and commodities, stocks and hedge funds, and even stocks and money market funds moved towards  a correlation of 1.00 (went down at same time and near the same magnitude).

2. Do a fundamental double-check of your portfolio before blindly trusting the correlation metrics you’ve come up with in analyzing the components. You may be a professional trader and found your Cocoa trading model has zero correlation to your Sugar trading model, and look to lever them both up at the same time knowing they aren’t likely to lose at the same time…. And that is right when you’ll find just how non spurious two related commodities being traded by two models developed by the same brain (yours). Same goes for you, Mr. Investor – that credit arbitrage hedge fund throwing off income currently with a zero correlation to the Nasdaq may become very non-spurious also, if credit tightening causes losses in stocks and the hedge fund.

Now, if we could just get the daily number of readers of our blog to correlate with the moves in the Japanese Yen, we would be onto something!

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Disclaimer
The performance data displayed herein is compiled from various sources, including BarclayHedge, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.

Benchmark index performance is for the constituents of that index only, and does not represent the entire universe of possible investments within that asset class. And further, that there can be limitations and biases to indices such as survivorship, self reporting, and instant history.

Managed futures accounts can subject to substantial charges for management and advisory fees. The numbers within this website include all such fees, but it may be necessary for those accounts that are subject to these charges to make substantial trading profits in the future to avoid depletion or exhaustion of their assets.

Investors interested in investing with a managed futures program (excepting those programs which are offered exclusively to qualified eligible persons as that term is defined by CFTC regulation 4.7) will be required to receive and sign off on a disclosure document in compliance with certain CFT rules The disclosure documents contains a complete description of the principal risk factors and each fee to be charged to your account by the CTA, as well as the composite performance of accounts under the CTA's management over at least the most recent five years. Investor interested in investing in any of the programs on this website are urged to carefully read these disclosure documents, including, but not limited to the performance information, before investing in any such programs.

Those investors who are qualified eligible persons as that term is defined by CFTC regulation 4.7 and interested in investing in a program exempt from having to provide a disclosure document and considered by the regulations to be sophisticated enough to understand the risks and be able to interpret the accuracy and completeness of any performance information on their own.

RCM receives a portion of the commodity brokerage commissions you pay in connection with your futures trading and/or a portion of the interest income (if any) earned on an account's assets. The listed manager may also pay RCM a portion of the fees they receive from accounts introduced to them by RCM.

See the full terms of use and risk disclaimer here.

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