What is mean reversion?
The average return on equity investments (without reinvestment of dividends) is about 18% over the past 31 years. Does it mean that every year you got 19%? The answer is no. Such ‘zero standard deviation return’ is possible only in CERTAIN debt instruments. In equity investments there have been years of +242% as well as -46%.
When you see years in which the stock market returns are say 90% – you know that immediately following that or in a couple of years you HAVE TO GET A NEGATIVE return, because the 90% return HAS TO REVERT TO 19% – REVERSION to the mean.
However there is no pattern of 38%, 0%, 19%….it can even be -242%, 29%, 45%, -32%…and slowly catch up with 19%. The theory says a given return (value) will continue to return to an average (return) value over time. It may happen that over a period of time the average itself will increase or decrease, but the impact will be far more gradual. This statistical measure can be applied to any measurable value, including interest rates, cricket scores of a team, batting and bowling averages as well as the return on a certain investment.
This theory is extended to a bunch of good fund managers too. Suppose you own A,….E five funds. There is a good chance that suddenly one fund may not be doing well. Do a lot of detailed research and then pump some extra money into it.
Of course you need to remember the old maxim ‘Winners rotate, losers remain at the bottom’ – so be careful!
Very funny how people use average returns when it comes to investing. They have no clue what will be the future returns. Neither does the fund manager, the agent, the RBI governor or the Prime Minister. So they end up seeing the past returns. This is like ‘I cannot see in front, so I will look in the rear view mirror and drive’. This works fine if you are driving in a desert or even a long road. You only hope you are not in choppy markets. Unfortunately, markets are choppy ALWAYS!!
In case of say gold the last 3 years average return is 32%p.a. – and so channels are urging a buy. The average return over a 30 year period is say 7%p.a. in rupee terms.
when you watch television channels urging you to buy gold remember the returns figure and the ‘mean reversion’ story..that is all..
aditya
engaging piece again Subra.
My understanding here is there are traps as well as serendipity for first timers with alpha gains and hence high expectations.
Milind N
Thanks Subra.Larger Picture is clear picture.How True !
Rajat
Brilliant Sir. Thanks for reminding us to control our greed and cut investment in gold at this point of time.
subra
sorry Rajat wrong learning. I did not say anything of this sort.
anon
Good one.
I target 15%, I chug along content.
pravin
well for gold to revert to the “mean”,it should be close to 5000 USD per troy ounce.mean reversion is not a predictor,it is a quirk of statistics.when you can buy 1 Dow etf for 1 ounce of gold,we can say they have reverted to historical means
also,means move all around the place,sometimes permanently because of ‘regime shifts’.
pravin
why is the 30 yr timeline so sacred? didnt the ‘regime shift” first in 1933 and then in 1971?-with changes in the world monetary systems? what if gold is today forecasting another shift in the monetary system? if you valuing gold as a commodity,it will never make sense.i’d rather value copper over gold as an industrial commodity.
Jsan
Hi Subra Sir, this reminds of the famous quote from Warren Edward Buffett, “In the business world, the rearview mirror is always clearer than the windshield”
subra
but the problem is even though you need the rear view mirror, you cannot look ONLY in the rear view mirror and drive.
Dr Mohammed Ali khan
@Subra @ Pravin
If you price gold in the Weimar German mark, Argentine peso, Zimbabwe dollars and countless paper currencies, Gold never returned to mean. Gold just flew-off the charts and these currencies fell-off a cliff!