Monday, December 1, 2014

The Importance of Reversion To the Mean in Investing. (Part 1)

The definition at least, is simple: When something happens that is not average, the following event is likely to be closer to the average.   But, the outcome is difficult to predict, understand and prone to illusions. 

Why is Reversion to the Mean important to consider?  In cases where Luck plays a large role in outcomes, such as prices of a stock, “Reversion to the mean is very powerful,” and “failure to regress outcomes sufficiently” causes people to “buy what has done well and sell what has done poorly” leading to the dumb money effect, (Mauboussin, The Success Equation).  Further: “Any activity that combines skill and luck will eventually revert to the mean.”  Howard Marks, when referring to this uses the term cyclical, but I believe it’s essentially the same.  But it’s important to realize that nothing can go up in price forever and down is only limited by zero, but otherwise cant go down forever.

Spierdijk & Bikker (2012), “Mean Reversion in Stock Prices: Implications for long-term investors,” summarized much of the literature.

Fama & French’s 1988 study explained 25%-40% of the variation in stock returns on mean reversion in long term investments over one year to ten years in duration.  Campbell & Shiller (2001) found that adjustments of the P/E ratio towards an equilibrium level was more by the price of the stock than the company fundamentals (price vs. quality).  Coakley & Fuertes (2006) found mean reversion behavior to be attributable to investor sentiment.  Further, mean reversion in stock indices of whole countries was almost absent in periods of low economic uncertainty, but of course very fast during high uncertainty or crisis.

In investing, mean reversion can occur in essentially every asset class, size of company, investing process, valuation model, and geographical boundary due to the roles of luck or randomness.

Mauboussin argues that people usually fail to revert their predictions sufficiently to the mean, and that its one of the biggest hazards decision makers face.   So it makes sense that when price regresses it should move more to the mean than you think it will, and that price often overshoots the mean.  The bigger the movement from the old price to the mean, and the momentum of that move seems to imply the possibility for a larger overshoot.

If everyone in the market is generally failing to calculate the amount of reversion to the mean that may occur, it seems a great contrarian view to take, that it will be greater than expected.  Howard Marks (The Most Important Thing) discusses a paradox where investors think quality rather than price is the main determinant of whether something is risky, yet price is more correlated with risk than quality.  A high quality stock is likely to be high priced and therefore far more at risk of reversion to the mean, despite its positive sentiment.

Contrarian strategies based on mean reversion in stock prices have been shown to yield excess returns, Balvers et al. (2000).  Further, generating risk adjusted excess returns by selling past winners, and buying past losers was profitable, De Bondt & Thaler (1985).  In other words there is less risk in mean reverting stocks especially over long investment periods. 

However, evidence of the actual existence of mean reverting behavior is harder to prove in stock prices, perhaps due to the difficulties in empirical assessments of mean reversion, and a risk averse investor should base investment decisions on conservative assumptions regarding mean reverting behavior occurring in a given timeframe, especially shorter durations, (Spierdijk & Bikker, 2012).    But once it occurs, expect it to exceed expectations of the magnitude of reversion.

Mean Reversion of a Slinky. (It always overshoots its mean!)

Reversion to the Mean does not need a cause.
We fail to predict to an adequate amount its effect when making predictions about the future.
Reversion to the Mean is most pronounced at extremes.  Things that are great won’t stay that great, things that are terrible rarely stay that terrible.
When a lot of luck is involved Reversion to the Mean is stronger, and inevitable.
The paradox of skill, (increases in the skills of investors and access to information, has narrowed the skill variation in the population, making luck more important in success), has lead to an increase in the power of Reversion to the Mean, (Mauboussin).

Untangling Skill & Luck – Mauboussin Article. Legg Mason Capital Management.

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