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. http://www.dnb.nl/en/binaries/Working%20Paper%20343_tcm47-271856.pdf
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!)
Summary:
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. http://vserver1.cscs.lsa.umich.edu/~spage/ONLINECOURSE/R15SkillandLuck.pdf
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