Issues With Reversion To The Mean for Investing
Reversion to the Mean:
Many investors believe there may be a way to predict when to buy and sell securities. One theory behind this belief is referred to as “Mean Reversion” – which can be defined as the idea that higher-than-average returns are followed by a period of lower-than-average returns, and vice versa. The extension of this idea is that if you can identify when this unusually high or low return period will end, then you could sell or buy securities at advantageous times and profit from this.
The embedded video from Jim Davis at DFA presents their study of Mean Reversion. Jim’s experience as a former academic comes shining through as he does an excellent job of introducing the idea and then describing their test of the theory. It’s worth a few minutes of your time, its about 4 mins and 30secs in length. Summarizing, tests were run in 15 stock markets around the world and in multiple asset classes, using several different trading ‘rules’ in each to discover whether any of these rules returned promising results.
The vast majority of the tests produced negative results (implementing the trading rule was harmful to returns). There are just so many challenges to profiting from a trading strategy like this; and Jim talks about some of these. While it’s interesting to note that some of these rules returned positive results, the mathematical reality is that so many tests were run that a few would be expected to produce positive results, simply by random chance.
This is much like giving 1,000 people a quarter and asking them to flip it ten times. Approximately 1 of these 1,000 will flip ‘heads’ all ten times. This obviously doesn’t reveal the one person with skill in coin-flipping, it demonstrates probability in action.
While the existence of mean-reversion cannot be ruled out, there just doesn’t appear to be enough evidence of a way to implement this strategy in a profitable manner.
Post contributed by Brad Rempe, CFP, AIF
Start a Blog:
No matter who you are, you will benefit from starting a blog. It's especially important now more than ever, as building your personal brand is part and parcel with any career. It has the additional benefit of serving as a platform to help add value to those you are working to reach as well as provide accountability for your goals, whether financial or otherwise. The process to get started has become quite simple and user friendly. As a reader of MSF going through the link will start you at a hosting rate of $3.95 per month. This comes with a free domain and their customer service has been great from day one.
Track All Your Finances:
Personal Capital is a free and easy to use platform that helps track your finances. Its a great tool to utilize to help track as your Net worth as you work to build it and eliminate your financial debts. Definitely recommend checking it out, as I have found it to be incredibly useful. Here is a preview of what the software will look we have put together for your review.
Join us by signing up for our newsletter and we will deliver article right to your inbox!