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Reversion to the mean is the phenomenon (discovered by Charles Darwin's cousin, Sir Francis Galton (1822-1911)) whereby a stock's average performance (or a mutual fund's, or many other non-investing statistics) tend to become more average (i.e., less extreme) over time. If true, this implies that recent good performers are perhaps somewhat more likely than average to be below average performers in the future (and vice versa). This idea is supported by much of the research.
A mathematical description of this generic concept: "Reversion to the Mean" is the statistical phenomenon stating that the greater the deviation of a random variate from its mean, the greater the probability that the next measured variate will deviate less far. In other words, an extreme event is likely to be followed by a less extreme event. Although this phenomenon appears to violate the definition of independent events, it simply reflects the fact that the probability function P(x) of any random variable x, by definition, is nonnegative over every interval and integrates to one over the interval . Thus, as you move away from the mean, the proportion of the distribution that lies closer to the mean than you do increases continuously
[Shiller] "Thus there is a sort of regression to the mean (or to longer-run past values) for stock prices: what goes up a lot tends to come back down, and what goes down a lot tends to come back up".
"I asked Daniel Kahneman, which of his 131 papers was his all-time favorite? "On The Psychology of Prediction" (1973, with Amos Tversky, Psychological Review, 80, 1973, pp. 237-251), he responded. This paper began when Kahneman and Tversky were at the Hebrew University in 1968. In tutoring Israeli Air Force flight instructors, they discovered the following: In conflict with psychologists' stock-in-trade (reward is far more effective than punishment in changing behavior), the instructors believed the opposite. The reason: Nearly every time they rewarded their student pilots, their performance declined. And nearly every time they punished their student pilots, their performance subsequently improved. How should a psychologist respond? Regression to the mean, explained Kahneman and Tversky. In flight maneuvers, progress between successive maneuvers is slow. It is likely that pilots who did well in one trial deteriorate in the next. Instructors wrongly attributed this 'regression' to the detrimental impact of their positive reinforcement -- an example of attribution error, attributing to human action what is in fact random. This erroneous and destructive feedback loop is ubiquitous. Armies of school psychologists labor intensively to repair the damage it causes. As Kahneman and Tversky conclude: "We normally reinforce others when their behavior is good and punish them when their behavior is bad. By regression alone, therefore, they are most likely to improve after being punished and most likely to deteriorate after being rewarded. Consequently, we are exposed to a lifetime schedule in which we are most often rewarded for punishing others, and punished for rewarding". (p. 251). This powerful insight, were it understood and applied in our schools, universities, businesses, families, shops, and public policies, could alone alter human society for the better. And there are 130 more where that came from".
Reversion in Action, Schultheis, 1999
If you want to live a long and healthy life conventional wisdom says that you should eat in moderation and exercise regularly. If you want to be a successful investor of common stocks conventional wisdom says you should spend lots of time analyzing companies or mutual fund managers and then try to pick the best ones. That is mistake #1. If you want to be a successful investor of common stocks forget about conventional wisdom and focus instead on reversion to the mean.
Bogle on Investment Performance and the Law of Gravity: Reversion to the Mean-Sir Isaac Newton Comes to Wall Street, Bogle, 1998
"... RTM is a rule of life in the world of investing—in the relative returns of equity mutual funds, in the relative returns of a whole range of stock market sectors, and, over the long-term, in the absolute returns earned by common stocks as a group".
Reversion-to-the-mean is not a glide path phenomenon, Bronson, 2000
This commentator notes that mean reversion doesn't mean that an investment's future performance is likely to gradually approach some asymptote. Rather, it is likely to cycle to the other extreme (i.e., good performance is likely to be followed by bad performance, and vice versa), which over time will cause the average performance to approach some asymptote. "Keep in mind that means of investment returns, like the underlying returns themselves, do not have a goal or a deterministic path so that mean reversion is probably best understood as simply reversion-to-the-extreme, much more like aperiodic pendulums than glide-path landings".
Temporary Movements in Stock Prices, Lewellen
"Mean reversion in stock prices is stronger than commonly believed. ... The reversals are also economically significant. The full-sample evidence suggests that 25% to 40% of annual returns are temporary, reversing within 18 months. The percentage drops to between 20% and 30% after 1945. Mean reversion appears strongest in larger stocks and can take several months to show up in prices".
A Mean-Reversion Theory of Stock-Market Crashes, Hillebrand, 2003
"Errors in the perception of mean-reversion expectations can cause stockmarket crashes. Using daily data of the Dow Jones Industrial Average and the S&P500 index I show that mean-reversion in returns is a transient but recurring phenomenon. In the case of the crash of 1987 I show that during the period 19821986 mean-reversion was higher than during the nine months prior to the crash. This indicates that meanreversion expectations were underestimated in 1987. This error was disclosed when in the week prior to the crash it became known that a surprisingly high volume of equities was under portfolio insurance and thus hedged against a faster reversion".
Mean Reversion in Equilibrium Asset Prices, Cecchetti, Lam and Mark, 1990