Mean Reversion

At Altor we are going to start an occasional series about the biases that can affect all of us whether we are advisers or investors. Before we do we wanted to look at one of the most quoted, simplest but least understood effects in our little world of tax and investments – reversion to the mean.

Mean regression is a statistical term for the observable truth that outstanding performance will typically be followed by a period of poor performance. This is because performance of anything is random and will just regress back to its average (so a peak will need a balancing trough to return to its average over time).

We see this in finance, and term it ‘reversion to the mean’, where stock prices or fund manager performance will fluctuate but return over time to the average price or performance.

Whilst the UK rock stars of fund management were Anthony Bolton and Neil Woodford the famous name in US fund management was Bill Miller who ran the Legg Mason Value Trust. He was famous for beating the US stock market every year from 1991 to 2005 when only 25% of managers can do that in any one year. An analyst at Legg Mason tried to calculate the statistical chance that this run was luck and found it to be vanishingly small. They were, however, working out the chances of Bill Miller outperforming the market for 15 years straight when in fact they should have been looking at the chances that ‘a’ fund manager at some point in history would outperform the market for 15 years straight. Framed like this it is actually highly likely that someone will do this, we just don’t know who.

So by now you might have guessed where this is going, Bill nearly wiped out his investors over the following 3 years. If you had been invested since the start (highly unlikely) you would have outperformed the market just about but if like most of his investors you had joined at the top you would have lost a lot of your money.

With hindsight we can now see that he was running much more risk from a concentrated stock portfolio and did better when markets were going up and worse when markets went down. So calamitous was his performance in the 07-09 crash that he is actually one of the characters in the Hollywood film ‘The Big Short’ with is worth a watch if you are not easily offended. He is the one that is on stage talking about his investment in Bear Stearns whilst all the brokers, realising his hubris, run for the doors on their Blackberrys trying to dump the stock. So Bill Miller mean reverted and was sacked by LG but there are still some publications out there pumping his new fund based on his unlikely past record.

The problem with mean reversion is that we tend to spot the peaks and troughs just after they have happened and attach a significance to it that isn’t justified. In UK wealth management the most obvious example is the fund management companies who heavily advertise whichever of their funds is the best performing over the last 3 or 5 years in any one period. This is damaging to people’s wealth because these firms often have lots of different funds and so there will always be one that they can promote for a period but they are promoting at the peaks and investors who follow the hype are investing at just the wrong point – ahead of the mean reversion. This is outrageous but what else are they supposed to do? No marketer is going to keep their job with the slogan ‘X fund has been worse than 90% of its peers over the last 5 years. Invest now and ride the mean reversion recovery.’

So can this knowledge be useful to us? Well not in the short-term (please ignore mean reversion trading strategies) because no one knows how long it will take a price to mean revert. In the long-term though there are lessons to be learnt.

  1. No one knows when the markets will turn and fall or turn and rise.
    • There is lots of data out there and little of it is useful.
    • Therefore you should invest when you are ready to invest and only for the long-term.
  2. No one knows who will outperform and when.
    • Any asset other than cash should rise above inflation and so you need a mix that suits you.
    • The mix you select should be one that won’t lose you so much in any year that you will panic and withdraw.
  3. No one can control investment results, so focus on the controllable in your finances; costs and tax.
    • If you engage an adviser only do so on the basis that their added costs can be more than covered by the tax saving and performance benefit of keeping you invested.
    • Never buy an adviser’s services based on claimed investment outperformance.

If you want a strategy to investing then you could do worse than employing the rollercoaster technique; closing your eyes and holding on tightly. Before you do though, know what your comfort level is for the stomach churn.

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