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Anyone who has sat through a statistics class has been exposed to the term “reversion to the mean,” or, as it’s often called, “mean reversion.” Even if you’ve never cracked a stats textbook, the basic concept is easy to understand: reversion to the mean refers to the statistical tendency of extreme or unusual results to be followed by more typical or average results over time.
Most of us understand this tendency intuitively. When meteorologists refer to “average temperatures,” for example, we understand that some days will be hotter than average, some will be cooler, but over time, daily seasonal temperatures will tend toward an average number. Similarly, in the financial markets, the prices of certain assets may go up or down by an unusual amount in a given period, but over time, their rate of return will move toward its average. So, if prices rise dramatically in one year, they may have a tendency to rise by a lesser amount – or fall – in the next year. Viewed over a long enough time, however, the variances will tend to flatten out, and we are able to discern an average. This process of “flattening” is the essence of reversion to the mean.
The problem for advisors comes when investors react to asset price movements that are well outside the “average.” This often leads to impulse-based financial decisions that are typically detrimental to the client’s long-term interests.
With an understanding of reversion to the mean, however, it is possible to contextualize market volatility for investors in a way that helps them view it more constructively.
Mean reversion and behavioral finance
Advisors understand the effect that various behavioral biases have on investors. These biases often result in assigning a cause-and-effect relationship to the mean reversion process. Human beings are pattern-seeking animals; we “want” to see patterns because they help us make sense of a sometimes-hostile universe.
Maybe you’ve heard of the “Sports Illustrated Jinx.” Supposedly, when any athlete’s picture appears on the cover of Sports Illustrated, they are doomed to go into a slump. But what’s happening is mean reversion. Why do athletes get their pictures on the cover of the magazine? Typically, it’s because of above-average performance. But mean reversion indicates that they are statistically due for a period of performance closer to the average. To an outsider, though, it can appear that being featured in SI is the cause, and the following slump is the effect.
Similarly, investors are prone to ascribe cause-and-effect relationships to asset price movements – last year’s performance of a particular mutual fund, for example – rather than allowing for the operation of mean reversion. Many investors, seeking to discern a pattern in price movements, ascribe a correlation between certain variables that, in fact, are either non-correlated or only weakly correlated.
If we can explain this principle to clients, it can help them react more constructively to market volatility. For example, a study by the Wall Street Journal found that certain domestic mutual funds achieving five-star ratings from the research firm Morningstar in a given year were more likely to receive lower ratings in the subsequent three, five, and 10 years. Does that mean that the fund managers became less proficient over time? Not necessarily. It does indicate that the performance of the funds reverted toward the statistical mean. In other words, a five-star rating in one year is only weakly correlated with the fund’s performance in later years. And yet, some investors will switch from fund to fund, based on recent performance, only to watch their most recently chosen fund revert to the mean.
Over time, this type of financial decision-making can cost dearly in extra fees, taxes and lost long-term value. On the other hand, investors who understand reversion to the mean might be more patient in the face of year-to-year variability, allowing for returns to move back toward the expected long-term average.
Mean reversion and portfolio construction
But advisors can also utilize mean reversion in ways that can set investors up for potentially better long-term results. When an understanding of mean reversion is coupled with an investor’s approach to broad asset classes, it can be a useful tool for constructing portfolios that are designed to take advantage of the way the markets work over time.
For example, the historical average return of equities (stocks) over the last century has been 10%. That is an average; some years the return has been much higher, and in others, it has been much lower. But over a sufficient period of time, an investor with an understanding of mean reversion might expect to earn an average return, over time, of about 10% from a stock portfolio.
Of course, we know that stock prices exhibit much more volatility than other investments, which means that in a given year, they frequently change by 15% or more, in either direction. But once again, mean reversion suggests that volatility, like other phenomena, tends to move back toward an average level over time.
Consider the above chart. When stock price volatility is viewed in a short time frame – one year in this example – it can be quite high. But when we look at volatility over a longer period – 20 years in the above chart – it approaches a much lower level, comparable to the volatility of bonds, which tend to exhibit much less short-term volatility than stocks.
This means that, for an investor with an appropriate time frame, mean reversion suggests both the likelihood of strong equity returns with only moderate volatility over time.
Keeping them in their seats
If advisors can effectively communicate a basic understanding of mean reversion to clients, there are benefits beyond portfolio construction. One of the most important advantages is emotional: you can help clients avoid making important financial decisions based on emotions stimulated by short-term price conditions. Simply knowing about the statistical realities behind asset price movements provides the calm perspective your clients need to remain committed and patient, even in the face of dramatic price swings. If they understand that both volatility and price performance tend to move toward average levels over time, you can help them resist the urge to “do something” when the better tactic would be to stay in their seats until the ride gets smoother.
Our clients depend on us to provide informed, research-based advice, especially when market conditions are uncertain. A basic understanding of the commonly observed statistical phenomenon of mean reversion is a valuable tool for redirecting them during disorienting market environments.
Scott Bondurant is the CEO and founder of Boundurant Investment Advisory. His prior roles include managing director and global head of long/short strategies at UBS Global Asset Management from 2005-2014. He was responsible for leading the development, implementation, and marketing of the UBS Global Asset Management’s $2.5 billion equity long/short platform. In addition, he has authored a series of white papers addressing topical issues related to long/short strategies. Scott was also a member of the equity management team, equity investment committee, and equity business committee at UBS. He is currently an adjunct professor at Northwestern University and has taught the course titled “The History of Investing” for 10 years. The Northwestern Business Review named this course as “one of the five coolest business-related classes.”
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
