The markets they are a-reverting


Have you heard the Bob Dylan song where he explains the basic principle of investing? No? You don’t think that Bob Dylan is the kind of guy who would bother about the financial markets? You’re wrong. There’s a song where he sings at one point, “For the loser now, will be later to win.” Later in the same song, he sings, “And the first one now, will later be last”. That’s the principle of reversion to mean, explained very nicely.


So what exactly is a reversion to mean? I would have given you the dictionary definition, but since I’m trying to keep up with the times, here’s what GPT4 says it is: In finance, “reversion to the mean” refers to the assumption that the price of an asset will move towards its average price over time. If the price of the asset has been above the mean, it is expected to decrease in the future, and if it has been below the mean, it is expected to increase.


While that definition refers to stocks, it’s just as applicable to almost all financial assets, including entire markets. That’s the reason it makes little sense to get too excited about the markets zooming to all-time highs or specific parts of the markets doing fabulously well. Similarly, it’s pointless to get panicky when the markets fall too sharply. However, the problem arises because investors do not understand the underlying idea and assume that the current trend will continue. Of course, in this belief, they are aided and abetted by those who stand to make money from them.


The lure of investing in whatever segment of the market is doing well at the moment is easy to pass off as research. Professionals (brokers, advisors, fund companies) as well as individual investors, can always justify investing in an industry by pointing out that it is doing better than others, the assumption being that it will continue to do better. If this excitement sustains long enough or strongly enough, then it becomes conventional wisdom – something ‘everyone’ knows. For sectors, this happened to tech stocks back in the heady days of 1999, and we all know how that ended. Around 2005-07, it happened to a set of industries that were loosely (forcibly?) defined as infrastructure. That ended up in just as big a blowup as tech in 2001.


Meanwhile, it also happens for segments of the market, like small-caps. Small-caps are especially prone to this phenomenon because the deviations from the mean are most severe. When they do better, they do much better. It’s easy to convince investors (or it’s easy for investors to convince themselves) that this means something when it doesn’t. When a sector or a segment sustains better-than-average performance for a noticeable amount of time, a bandwagon gets created around it. Fund companies launch funds or start pushing the ones that already exist. Investment advisors start talking about it, seeing a clear short-term win if the trend holds. For a while, the trend does hold. At this point, it looks sub-optimal to invest in a diversified way. The thing to understand is that this almost always happens. Since some sector or the other is always certain to be doing better than the average, having a diversified portfolio always looks like a foolish choice.


And then, as the investment analyst Bob Dylan explains, the averages assert themselves, and the segment starts performing below average, and the returns revert to the mean. Those who join the party late are left with a negative outcome. The reversion to mean often results in the formerly best segment falling to the absolute bottom and creating losses even when the rest of the market is booming. And so it goes on, year after year, decade after decade.


The right option is to keep investing steadily, in a diversified manner, preferably through SIPs. It’s not complicated, but avoiding the hype takes effort.


Source- Valueresearchonline

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