Reversion to the Mean

One of the most important concepts in investing is reversion to the mean. This is a fancy way of saying things tend to return to normal.

You have probably noticed that like a pendulum the stock market is subject to wide swings up and down, and like a pendulum spends little time in the middle. This is true of the market as a whole and in the groups and individual securities that make up the market. Everything seems to go too high or too low.

Look at the chart above of the S&P 500 rolling monthly returns from 1975 to 2006. The mean (average) return for this period was about 13% but the rolling annual returns varied from up almost 50% to down nearly 30%. While there is no rhyme or reason to the swings of this pendulum you should be able to see that when things look the best you should be taking some profit, and when things look the worst you should be buying bargains. Trouble is this goes against what comes naturally.

This process of reversion to the mean takes place in all subsets of the market too. Remember tech stocks in late 99 and early 00? Or telecom? Or oil? For the last few years small caps have been outperforming and many on Wall Street have predicted a resurgence in large company growth that has yet to materialize, but has shown recent strength relative to small and mid size companies. Maybe it is finally time for their reversion to the mean.

The first step to profiting from this phenomenon is to recognize its existence. The next step is to have the discipline and courage to act. Remember, things are never as good or as bad as they seem.

technorati tags:Finance, investing, Stocks