“Mean Reversion”: The Least Sexy But Dependable Reality In Investing

Every night, television personality and former hedge fund manager Jim Cramer ends his “Mad Money” show with the same message: there’s always a bull market somewhere – and we promise to try and find it just for you.

Jim’s team must of worked a lot of nights and weekends in 2018 then. Last year, for the first time in nearly fifty years, no major asset classes gained 5% on the year. In fact, only Barclays U.S. Aggregate Bond Index finished up – and it gained just 0.01% for the year.

This was a remarkable and obviously disappointing turn of events for investors. Typically, reliable indices like the S&P 500, Russell 2000 and MSCI Emerging Markets were all down. Other major bond, commodity and real estate classes were subdued too. The phenomena contrasted the markets’ general trend where about half of major asset classes typically do well in a given year.

No way around it: 2018 was strange.

The fact that entirely uncorrelated asset classes and even those supposedly “inversely” correlated all declined was an anomaly. Fortunately, for investors that are broadly diversified with assets across a mix of classes, a time-tested financial force is at work in their favor.

It’s called: reversion to the mean.

We won’t bore you with a statistical treatment of the idea. Simply, it’s the principle that over time asset returns are generally stable and will move toward their average. One way to think about it is “financial symmetry”. For example, asset prices go back above their average price after a period of being below to deliver returns around a historical average. Conversely, if an asset’s current value is above a well-established fair value, the market tends to move back down.

This is a time-honored investment reality and, when you think about it, the historical indicator behind the saying, “buy low, sell high.” But of course, in practice, it’s difficult to fully capture.

Markets can be wildly and randomly volatile in the short term. Fueled by giddy or fearful investors, prices can swing on both the up and downsides during correction seasons.

But, what occurred in 2018 won’t likely be future reality.

In fact, if investors expand their market perspective a bit, the future looks remarkably bright. Even if the next few months or years deliver a season of slower economic growth and performance.

The compounded annual growth rate (CAGR) of stocks over the past twenty years has been about 5.5%. Decent, but not great. The clock on this period, however, didn’t start ticking until after major bull markets in the 1980s and in the tech-infused run of the 1990s. But it did include two massive bear markets in 2000 and 2007. These, according to DataTrek Research, each ate negative 35% or more from annual returns and marred CAGR performance. Today, despite the bull run just prior to 2018, we still sit with the worst average trailing twenty-year growth rate for the S&P 500 since the Great Depression. Going back almost 100 years, the average 20-year market CAGR has been over 10%; virtually double where we are today.

Investors rarely look at time periods this long and associated trailing performance and market events. But it provides useful context as we look ahead.


Again, because of reversion to the mean.

Perhaps the economic uncertainty and talk of market upheaval isn’t as relevant for the long term as today’s news headlines suggest. Because if history shows anything it’s that a period of massive underperformance against normal, average returns will result in a swing the other way. Remember: our twenty-year run is startlingly low on a historical scale.

Think back on your elementary arithmetic: if something has a 5% return and its average is 10%, it needs to deliver 15% for the math to work. Of course, the same is true for periods of overperformance. Good times never last forever.

On the topic of mean reversion, Vanguard-founder and investing sage John Bogle once offered this:

“While its drumbeat is hardly regular, it never fails. For the returns of market sectors, of managed investment portfolios, and even of the market itself mysteriously return, over time, to norms of one kind or another.”

It may take longer than we want for the market to move in the direction we expect. And we may not be able to determine precisely the nature of these movements. Fortunately, time has shown that the idea is REAL and we can press on knowing that it’s not a matter of IF, but WHEN that mean reversion is coming.

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