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..

 

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