I try my best to avoid financial jargon, but “mean reversion” is one piece of jargon well worth being acquainted with.
The “mean” is just a fancy way of saying the average. The concept of mean reversion then, is that investments and markets tend to want to pull back to their average over time.
This week we’re going to dig into what mean reversion is, and perhaps more importantly, its implications for you as a long term investor.
What do you make of statements like Warren Buffett’s advice to “be fearful when others are greedy, and greedy when others are fearful”?
Or Baron Rothchild’s “the time to buy is when there’s blood in the streets”?
How about Fed Reserve chief Allan Greenspan’s “Irrational Exuberance”?
These statements all share a common concept, something that most of us possess in our deep thinking, common sense brain, but sometimes forget amidst the short term noise. These pearls of wisdom all rest on the assumption that mean reversion will ultimately prevail.
In the short-term market returns are quite random. We can see this in returns for the Australian share market over the past few years. In the 2022 financial year the Australian market was down 7.4%. The year before it was up 30.2%. And the year before that it was down 7.2%.
All over the shop!
Yet when you zoom out and consider the average return, whether you look at 20, 30 or 50 years, you see a return inclusive of dividends of around about 10% per year. To grasp the concept of mean reversion, think of this long-term average as a magnetic force. When market returns are unusually low, the mean reversion magnet tends to want to pull returns back up to the long term average. In reverse, when returns have been unusually high, the mean reversion magnet tends to want to pull returns back down so that the long-term average continues to prevail.
When we invest, we all want to see growth. As long term investors we know that there are often periods of weakness that we need to endure. The concept of mean reversion is a useful way to help you stay the course. Ultimately, the long term average return will prevail. A year or two of poor returns will require some above average returns in subsequent years in order to square the Ledger and balance things out. This idea is consistent with the concept of cycles that we particularly see across the economy. The economy goes through a buoyant period of strong economic growth, profitability, and employment. But at some point it gets too much and there’s some sort of inevitable bust that sees everything slow. Roll forward a few years and optimism slowly regains ascendancy, pushing us into the next period of growth. Mean reversion in investment markets, and economic cycles, are very much close cousins, not necessarily in their timing, but just in there operation.
Mean reversion is not so useful at the individual company level for long term investors. A company share price might drop as it heads towards bankruptcy. No mean reversion magnet is going to pull that price back up to a long term average once the company goes out of business. On the flip side, a strongly growing company may very well have a constantly growing share price reflecting it’s increased profits over time.
Short term traders may use mean reversion as a trading tactic by endeavouring to spot when prices are temporarily above or below where they should be. Short term trading however is in the same paddock as gambling, and that’s not somewhere that we are interested in spending time.
Mean reversion is probably an idea you had in your brain but didn’t have a name for. It’s an idea well worth keeping in mind though. When markets are booming, recognise that at some point the wheels going to turn, with some inevitable poor years. And likewise in the midst of weak markets, consaul yourself with the knowledge that the forces of mean reversion will ensure that long term investors like you are appropriately rewarded. All it takes is patience.
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