Skip to main content

Proving Causation in Finance



I said in an entry last week that a downgrade from Morgan Stanley was a reasonable candidate for the cause of a downward stock price move, as we intuitively understand the idea of cause.

But proving this would be a trickier matter. It would require showing that there was nothing else happening that evening or morning that may also have had consequences for that demand. Or, if there were other things happening, if would require some measure by which we could distinguish this causation candidate as more potent that the others.

Even if it is a very general rule that similar announcement proceeds stock price fall, other explanations are possible. After all, since we’re assuming that Morgan Stanley’s analyst was working from publicly available information, we could hypothesize that a lot of traders and in-house buy-side analysts reached the same conclusion at the same time Joe Smith did and would have reached it even if Joe Smith had had nothing to say, or had through some analytical failure of his own reached the contrary conclusion.

If we had easily repeatable conditions, as in a chemistry laboratory, we could address this. Let’s re-set everything so that it is exactly as it was last Tuesday, and let the world run forward again from that moment with only one difference: Morgan Stanley’s report doesn’t go out (or, in a variant, perhaps it does go out to a favored paying clientele but is not widely reported in free media.) Does the price go down then? 

Sorry: that kind of experimentation isn’t feasible.

So what can we do to get some sense of how cause and effect applies to market movements? We have to work with some background assumptions, and of late the dominant background assumptions are those of probability theory.

Mathematicians studying probability talk a good deal about the normal or Bell curve. Suppose you are measuring the errors of 17th century cartographers. Sometime, you find, those old mapmakers got distances just right. Sometimes they overstated the distance. Sometimes they understated it. You might collect a lot of old maps of England and measure how far off they were (and in which direction) in displaying the distance between London and Plymouth.

You’ll likely find this: the largest group of mapmakers got it right – showing the two places at 191 miles apart by the flight path of a crow. Among those who made mistakes, the mistakes were likely symmetrical: there are as many mapmakers showing it as a 171 mile distance as there are those who show it at 211 miles. The larger the mistake, the less likely: so that it would be truly extraordinary to find a map showing this distance as 151 miles, or as 231. Thus, you could chart the errors by drawing a curve that would indeed look a bit like a bell.

Comments

Popular posts from this blog

A Story About Coleridge

This is a quote from a memoir by Dorothy Wordsworth, reflecting on a trip she took with two famous poets, her brother, William Wordsworth, and their similarly gifted companion, Samuel Taylor Coleridge.   We sat upon a bench, placed for the sake of one of these views, whence we looked down upon the waterfall, and over the open country ... A lady and gentleman, more expeditious tourists than ourselves, came to the spot; they left us at the seat, and we found them again at another station above the Falls. Coleridge, who is always good-natured enough to enter into conversation with anybody whom he meets in his way, began to talk with the gentleman, who observed that it was a majestic waterfall. Coleridge was delighted with the accuracy of the epithet, particularly as he had been settling in his own mind the precise meaning of the words grand, majestic, sublime, etc., and had discussed the subject with William at some length the day before. “Yes, sir,” says Coleridge, “it is a majesti

Five Lessons from the Allegory of the Cave

  Please correct me if there are others. But it seems to be there are five lessons the reader is meant to draw from the story about the cave.   First, Plato  is working to devalue what we would call empiricism. He is saying that keeping track of the shadows on the cave wall, trying to make sense of what you see there, will NOT get you to wisdom. Second, Plato is contending that reality comes in levels. The shadows on the wall are illusions. The solid objects being passed around behind my back are more real than their shadows are. BUT … the world outside the the cave is more real than that — and the sun by which that world is illuminated is the top of the hierarchy. So there isn’t a binary choice of real/unreal. There are levels. Third, he equates realness with knowability.  I  only have opinions about the shadows. Could I turn around, I could have at least the glimmerings of knowledge. Could I get outside the cave, I would really Know. Fourth, the parable assigns a task to philosophers

Searle: The Chinese Room

John Searle has become the object of accusations of improper conduct. These accusations even have some people in the world of academic philosophy saying that instructors in that world should try to avoid teaching Searle's views. That is an odd contention, and has given rise to heated exchanges in certain corners of the blogosphere.  At Leiter Reports, I encountered a comment from someone describing himself as "grad student drop out." GSDO said: " This is a side question (and not at all an attempt to answer the question BL posed): How important is John Searle's work? Are people still working on speech act theory or is that just another dead end in the history of 20th century philosophy? My impression is that his reputation is somewhat inflated from all of his speaking engagements and NYRoB reviews. The Chinese room argument is a classic, but is there much more to his work than that?" I took it upon myself to answer that on LR. But here I'll tak