Mean Reversion’s Applicability for Long Term Investors

The term “mean reversion,” which is often used in financial jargon and should be familiarized with, is worth knowing.

The “mean,” which is just another way to say the average, is a very common term. The idea of mean reversion is that markets and investments tend to return to their averages over time.

This week, we will explore what reversion means and, perhaps more importantly, the implications it has for you as an investor with a longer-term perspective.

What do you think of Warren Buffett’s statement, “Be ,greedy when other people are afraid, and fearful when they are greedy”?

Or, Baron Rothchild’s “the best time to buy is if there’s blood on the streets”?

What about Fed Reserve head Allan Greenspan’s “Irrational Exuberance?”

All of these statements share a concept that we all possess but often forget in the midst of short-term noise. All of these pearls rest on the assumption that reversion is going to win out in the end.

Short-term market returns can be quite random. This is evident in the returns of the Australian stock market for the last few years. The Australian market fell 7.4% in the financial year 2022. The previous year, it had grown by 30,2%. The year before, it was down 7.2%.

The shop is awash with all kinds of merchandise!

When you zoom out to look at the average return over 20, 30, or 50 years, you will see that it is around 10% per annum, including dividends. Imagine this long-term average as a magnet to understand the concept of mean return. When returns on the market are low for a long time, the magnet of mean reversion tends to try to bring them back to the average. When returns are unusually high, mean reversion tends to want returns to fall back to the long-term average.

We all want to see a return on our investments. We know as long-term investors that there will be periods of weakness. Mean reversion can be a helpful tool to keep you on track. The long-term average return will ultimately prevail. In order to balance the Ledger, a year or two with poor returns will need some returns above average in subsequent years. This idea is in line with the concept that we see throughout the economy. The economy experiences a period of high economic growth, profitability, and employment. At some point, it becomes too much. Then, there is a sort of inevitable crash that causes everything to slow down. After a few more years, optimism gradually returns, and we enter the next phase of growth. The mean reversion of investment markets and the economic cycle are close cousins, not necessarily in terms of timing but in terms of their operation.

Investors who are interested in the long-term performance of individual companies may not find it useful to use mean reversion. As a company approaches bankruptcy, its share price may drop. Once the company is out of business, no reversion magnet will be able to bring that price up to its long-term average. A company that is growing rapidly may have a share price that continues to increase over time.

Short-term traders can use mean reversion to identify when prices are temporarily higher or lower than they should. We don’t want to spend time on short-term trading, which is gambling.

You probably had an idea in your head but did not know what to call it. This is a good idea to keep in mind. Recognize that the market will eventually turn, and there will be some bad years. In weak markets, you can also be confident that mean reversion forces will reward long-term investors. It’s all about patience.

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