The law that I am going to talk about is like… Gravity.
It has the same effect on investments as gravity has on all of us.
I am talking about Mean Reversion.
This law broadly means that above-average performance will eventually move back towards the average and below-average performance will move up towards the average. It’s a tendency of extreme performers (on both high and low sides) of one period to deliver opposite performance in future – thereby bringing long-term results closer to average, i.e. revert towards the mean.
A proper understanding of mean reversion can make you a lot of money. On the other hand, ignoring it can pull down your investments in a big way… just like things falling under the influence of gravity.
This reminds me of Jason Zweig’s words a while back:
“From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.”
Mean reversion is a ‘pull’ towards historical averages. In the case of investing, it can be in returns as well as in valuations.
Talking of returns, periods of above-average performance are usually followed by below-average returns. Whereas periods of below-average performance are typically followed by above-average returns.
In fact, if returns have been poor in the recent past, then at least statistically speaking, the chances of getting good returns going forward are higher. And here is a small study I did a little while back – Last 3 years vs Next 3 Years.
Let’s talk about valuations now.
If you bought stocks (or maybe index in this case) when the valuation was below average, you would eventually benefit from an increase (or reversion) in its valuation towards the mean.
On the other hand, if you bought when valuations were above average, you are quite likely to experience a fall in valuations eventually, which in turn will lead to losses if earnings don’t increase to counter the fall in valuation multiples. And here is one solid proof for that. Though a few years old but still gets the message across.
Several explanations have been suggested for why returns tend to mean revert, with investor overreaction being the most widely accepted. When investors have limited information, they tend to focus on sectors, regions, or companies with the most optimistic outlooks. These are often assets that have shown strong price growth recently, reinforcing a positive narrative. However, investors often make the mistake of assuming that this past success will continue indefinitely, which is much less probable. So, one should always look at reliable sources of historical periods for FirstRate Data to draw out any conclusions and then build their investment views.
So ideally, if you invest when valuations are low (towards the lower extreme), you are making yourself eligible for big profits in future when valuations move up (revert towards the mean and move even higher). Of course, this eligibility is not a guarantee. J But that’s how mean reversion works.
It’s like a pendulum that travels from one extreme to another, passing from the mean central position.
Though there is enough proof available for mean reversion, I would also say that it’s not a bullet-proof concept. There is no guarantee that what has happened in the past will happen again in future.
Blindly betting on mean reversion can be risky too.
So, you need to keep that in mind.
Also, mean reversion can take years to play out. So being patient and having a long-term outlook are the keys.
I generally feel comfortable using a valuation lens (though without ignoring growth/future aspects). But the school of value investing is also, in a way built on the premise of mean reversion – A value investing strategy naturally relies on the idea of mean reversion. The goal for a value investor is to identify assets that are undervalued, meaning their market price is below what they’re actually worth. This usually happens when a stock has underperformed or hit new lows.
Now more common investors who invest via mutual funds, tend to look for funds that have done well in the recent past. But just because a fund has done well in the past doesn’t mean it will do well in future too. Isn’t it? This is mean-reversion at play. Though it’s given as a disclaimer that ‘Past performance does not guarantee future results. You should not rely on any past performance as a guarantee of future investment performance’, the fact is that once again, it is the mean reversion at play. At least to an extent. Good performance cannot continue forever. Trees don’t grow and reach the skies.