Let’s regress to the mean together

…but before we do that, allow me to elaborate a bit on it.

Regression to the Mean (RTM) is the tendency for trends to flip with the passage of time; it’s nature’s way of levelling the playing field.  Most things on Earth revert to the mean over time and this includes investing as well. 

It means that whenever you hope that a very high investment return would continue, the odds would be overwhelmingly against you.

I, personally, always want to consider the statistical phenomenon RTM as a possible cause of an observed change in my decision making process.

Admittedly, that’s easier said than done, since our mind is strongly biased towards causal explanations and doesn’t deal well with “mere statistics”.

RTM has an explanation but it doesn’t have a cause, and this makes it far from obvious and doubly important to be sensitive to its frequent occurrences:

Because of RTM, weather fluctuates around a mean.

Because of RTM, stocks, mutual funds, and investment managers tend to look hottest just before they go cold.

Because of RTM, once a bull move in the markets is over, the bearish phase will usually retrace most of the previous move.

Because of RTM, a soccer club replacing a coach after a string of losses will be more successful under the new celebrated coach.  And that successful club from which the celebrated coach came from will be less successful.  This’s just a dual illusion created by the Regression to the Mean.  The few things a coach can control are dwarfed by the factors beyond the coach’s control (players’ injuries, referees’ being imperfect, game fixtures, individual players’ form, and above all, luck).  The same applies to companies in the real economy.

Because RTM would make a business commentator’s announcement that “the business did better this year because it had done poorly last year” a very plausible explanation but the business commentator’s tenure with that TV-station a very short one.

Because of RTM, all high-return companies succumb to it sooner or later (greater managers make it later).  Significant M&A activity almost always suggest a company’s returns are gravitating towards the cost of capital.

Because of RTM, real portfolio diversification is essential.  In scenarios where one sector of the stock market or one asset class is hot, diversifying your money across other sectors/assets might feel like a waste of effort—an umbrella you never seem to need.  It’s a mistake, however, to think you don’t have to be diversified.  No matter how many times you carry an umbrella without needing it, you will be very glad indeed to be carrying one when a downpour finally hits.

Because RTM statistically punishes us for being nice and rewards us for being nasty.  We tend to be nice to other people when they please us and nasty when they don’t.  Statistically, they will be less pleasing and less nasty, closer to the mean in future though.

Because of RTM, children of elites will be on average only slightly smarter than the median population. (Thank you Christopher Ng for this last minute addition to my post).

Because of RTM, highly intelligent women tend to marry men who are less intelligent than they are.

Regression effects can be found wherever we look, but we don’t recognize them for what they are.  It’s undoubtedly the most powerful force in financial physics; therefore, falling for the RTM-Fallacy would have destructive consequences to your investment returns.

But we both, of course, wouldn’t be falling for that, right?

 

“Mimicking the herd invites regression to the mean.” — Charlie Munger

“Remember, half the people you know are below average.” — Words of Wisdom