Hazards of Extrapolating Returns
Mean Reversion: The “Iron Rule”
It is no secret that over the last three years, the US stock market has performed incredibly well despite headwinds from COVID-19. An accommodative Federal Reserve, a low interest rate environment, and fiscal stimulus supported S&P 500 returns of 31.5% in 2019, 18.4% in 2020, and 28.7% in 2021 (dividends included). The excellent performance of stocks over this period sometimes leads investors to forget that, historically, periods of high returns like this rarely persist for long. Instead, markets tend to gravitate toward a long-term average over time, a phenomenon known as “mean reversion.” Jack Bogle, founder of The Vanguard Group, famously said, “reversion to the mean is the iron rule of financial markets.”
To illustrate this concept, if you were to flip a coin five times, each flip could result in heads. And yet we shouldn’t expect subsequent coin flips to result in heads each time. In fact, if you flip the coin an additional 1,000 times, the rate of heads occurrences should regress to 50%. Similarly, it’s certainly possible that stocks have an excellent return over certain periods, but such performance is unlikely to persist forever into the future and should regress to the long-term average.
Meanwhile, as humans, we’re wired to expect shorter-term trends to extend further into the future. In behavioral finance terms, a “recency bias” is our inherent inclination to rely on recent events without fully recognizing or accepting the true likelihood of those events continuing. As a result, investors sometimes irrationally make decisions based on what’s happening in the moment in markets as opposed to what longer-term, historical trends might otherwise suggest.
And while a good conceptual example, coin flips have one major difference compared with stock market outcomes. With flipping a fair coin, we already know that over enough trials, the long-term frequency of the outcomes should revert to 50/50. In markets, however, there is no way to know that number. Markets are extremely complex, and over different periods, we can expect the same asset to perform very differently, sometimes over long time periods, because of market events like a recession.
Because of the tendency for many assets to mean revert, investors should avoid chasing performance and should instead maintain a diversified portfolio over the long term. By owning a mix of stocks, bonds, and alternative investments versus just one of those asset classes, investors can reduce these fluctuations and provide better risk-adjusted returns over time. As we head into 2022 after several years of excellent stock performance and some potential market headwinds, it is important to keep this in mind and avoid some of the pitfalls of extrapolating past performance.
 Powell, Robin. “Francis Galton and the Iron Rule of Markets.” Evidence Investor, January 16, 2018. https://www.evidenceinvestor.com/francis-galton-iron-rule-markets/#:~:text=%E2%80%9CReversion%20to%20the%20mean%2C%E2%80%9D,than%20supposedly%20more%20sophisticated%20investors.
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