April 19, 2015 Admin | April 19, 2015 Understanding reversion to the mean is very important when investing your money. Why?
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What goes up must come down and what goes down will likely go up, that is a very important lesson to learn when investing. If a stock has been going up 30% the last 3 years and its average is only 10%. There is a good chance that it will have some lackluster years coming for it. If a stock has been down the last few years, it may take a very large gain coming soon, emerging markets is a good one to look at for those crazy swings one way or the other. Dont follow performance, you are better off going for lackluster performance in recent years on something with a good average return.
Reversion to the mean reminds you to expect investment returns to follow historical averages. Theoretically for this to hold true it will take a year of returns below the historical average to balance a year of returns above the average. On a basic level, if the average is 10% but the market earns 12% this year, expect a year of 8% returns to balance out the above average year. Even though the average is 10%, you may never actually see a year that returns exactly 10%. More importantly, understanding how averages work will help you avoid the temptation to invest at the peak of a bubble. Seeing many years of big returns in farm land, home prices, gold, or even tulips, makes it tempting to join the party. However, history has shown us that many years of big returns leads to many years of little return, no return, or loss. An example could go like this: assume historical average is 10% but the market has returned 20% the past five years. It will take 5 years of no return (0%) to get back to the historical mean (avg), or two years of -15% return, etc. Understand reversion to the mean and you will avoid the hype of hot markets and the pain of those bubbles popping.
It is important to understand reversion to the mean because it will help you to see that your returns are most likely to follow a historical average. If you are getting above average returns for one investment, you cannot expect it to stay that way; your investments will go back to their average level of returns over time. The same is true for lower returns. If your investment is seeing lower returns than normal, in understanding this concept you would know that it will eventually rise back to its average level of return.
Reversion to the mean is important to understand so one will not chase past performance. It natural to belive that because something is going up it will continue to do so, but historical averages tell us that the current trends will not sustaine. By chasing past performance you are missing out on some of that upswing and almost certain to catch most or all of the next downswing. It’s an especially good concept to grasp when rebalancing your portfolio. Understanding that the poor performers will bounce back and high flyers can not sustaine will help you maximizing the return of your allocation. Rebalancing back to your original allocation takes the guess work out of it and is a natural way to buy low and sell high.
Many wonderful answers everyone. Let’s recap.
(1) Understanding reversion to the mean can help you avoid herd behavior. The herd jumps on the bandwagon on the up or down swings of the market. Separate yourself from them and watch your portfolio benefit. Awake!