Reversion to the Mean
One of the most important concepts in investing is reversion to the mean. This is a fancy way of saying things
tend to return to normal.
You have probably noticed that like a pendulum the stock market is subject to wide swings up and down, and like
a pendulum spends little time in the middle. This is true of the market as a whole and in the groups and individual
securities that make up the market. Everything seems to go too high or too low.
Look at the chart above of the S&P 500 rolling monthly returns from 1975 to 2006. The mean (average) return for
this period was about 13% but the rolling annual returns varied from up almost 50% to down nearly 30%. While
there is no rhyme or reason to the swings of this pendulum you should be able to see that when things look the
best you should be taking some profit, and when things look the worst you should be buying bargains. Trouble is
this goes against what comes naturally.
This process of reversion to the mean takes place in all subsets of the market too. Remember tech stocks in late
99 and early 00? Or telecom? Or oil? For the last few years small caps have been outperforming and many on
Wall Street have predicted a resurgence in large company growth that has yet to materialize, but has shown
recent strength relative to small and mid size companies. Maybe it is finally time for their reversion to the mean.
The first step to profiting from this phenomenon is to recognize its existence. The next step is to have the
discipline and courage to act. Remember, things are never as good or as bad as they seem.
Rebalancing Act
My previous entry on reversion to the mean may have seemed a little academic, but it has a very practical
application in managing your portfolio. Over time investments, like closets, tend to become disorganized. You may
have spent considerable time and effort in setting up an asset allocation for your 401k, but if you stop there you
will eventually have a portfolio that no longer meets your needs, and could potentially expose you to much more
risk than you originally intended.
Rebalancing your portfolio can insure that your risk remains tolerable, and can actually improve your investment
returns over time. There is always disagreement over when you should rebalance, some prefer quarterly, some
monthly, some have complicated formula's that trigger rebalancing. You can put me in the annual camp. When I
have looked at hypothetical portfolios and compared annual to quarterly rebalancing I usually find that annual
rebalancing provides more return, while quarterly rebalancing does a better job of reducing risk. No matter what
choice you make, the process of rebalancing can benefit you.
The reason rebalancing works is that "reversion to the mean" shows that different asset classes and subsets
within those classes go through periods of under performance and out performance. By rebalancing your
portfolio you force yourself to take some profits in areas that are outperforming, and purchase securities that
have become relatively cheaper. This goes against human nature because we all tend to want all our money in
whatever is providing the best return right now. Just remember that all things in life have cycles. You may not be
able to predict when a cycle will begin or end, but you do know that it will. Rebalancing provides discipline to your
investment process and can keep you from making the big mistake of being late to the party and late to leave,
like the dot com investors of the last bull market.
Investment Wisdom
With the stock market in a late summer swoon, I thought some pearls of wisdom on the art of investing might take
your mind off the non stop "the sky is falling" gibberish on CNBC. I hope you enjoy these.
Russian Roulette
Nick Murray is a well known figure inside the investment advisor community. He could be called an advisor's
advisor. A prolific writer with a dry style and laser sharp insight his monthly columns in Financial Advisor magazine
are greatly anticipated.
This past month Nick chose to discuss concentrated stock positions. He weaves an interesting story about one of
the bluest of blue chips, Merk. Noting that over the years Merk has been an excellent investment creating great
wealth for shareholders. But then on September 30, 2004 Merk announced that it was withdrawing the
blockbuster drug Vioxx from the market. You can remember the story from there. Fear of class action lawsuits and
memories of how asbestos decimated the building industry in the 1980s and how silicone implants crippled Dow
Corning came flooding to the public consciousness.
Merk opened down 27% the next day and eventually bottomed about 70% off its highs. Nick then coins one of the
phrases he is famous for: "You can get rich by under diversifying. But you cannot stay rich by under diversifying."
Wow! What a great way to sum up in a nutshell a lesson that could have saved millions of dollars for the
employees of Enron, Cisco, Sears, Xerox, and a host of past Wall Street darlings that eventually fell on hard
times. In fact, Nick likens overly concentrated stock holdings to playing Russian roulette with your financial future.
You may be okay today, "but tomorrow may be the day when the sun comes up on your Vioxx."
Nick's advise? "Sell every share you have to until that stock is no more than 20% of your net worth...and do it by
nightfall."
One of the most important concepts in investing is reversion to the mean. This is a fancy way of saying things
tend to return to normal.
You have probably noticed that like a pendulum the stock market is subject to wide swings up and down, and like
a pendulum spends little time in the middle. This is true of the market as a whole and in the groups and individual
securities that make up the market. Everything seems to go too high or too low.
Look at the chart above of the S&P 500 rolling monthly returns from 1975 to 2006. The mean (average) return for
this period was about 13% but the rolling annual returns varied from up almost 50% to down nearly 30%. While
there is no rhyme or reason to the swings of this pendulum you should be able to see that when things look the
best you should be taking some profit, and when things look the worst you should be buying bargains. Trouble is
this goes against what comes naturally.
This process of reversion to the mean takes place in all subsets of the market too. Remember tech stocks in late
99 and early 00? Or telecom? Or oil? For the last few years small caps have been outperforming and many on
Wall Street have predicted a resurgence in large company growth that has yet to materialize, but has shown
recent strength relative to small and mid size companies. Maybe it is finally time for their reversion to the mean.
The first step to profiting from this phenomenon is to recognize its existence. The next step is to have the
discipline and courage to act. Remember, things are never as good or as bad as they seem.
Rebalancing Act
My previous entry on reversion to the mean may have seemed a little academic, but it has a very practical
application in managing your portfolio. Over time investments, like closets, tend to become disorganized. You may
have spent considerable time and effort in setting up an asset allocation for your 401k, but if you stop there you
will eventually have a portfolio that no longer meets your needs, and could potentially expose you to much more
risk than you originally intended.
Rebalancing your portfolio can insure that your risk remains tolerable, and can actually improve your investment
returns over time. There is always disagreement over when you should rebalance, some prefer quarterly, some
monthly, some have complicated formula's that trigger rebalancing. You can put me in the annual camp. When I
have looked at hypothetical portfolios and compared annual to quarterly rebalancing I usually find that annual
rebalancing provides more return, while quarterly rebalancing does a better job of reducing risk. No matter what
choice you make, the process of rebalancing can benefit you.
The reason rebalancing works is that "reversion to the mean" shows that different asset classes and subsets
within those classes go through periods of under performance and out performance. By rebalancing your
portfolio you force yourself to take some profits in areas that are outperforming, and purchase securities that
have become relatively cheaper. This goes against human nature because we all tend to want all our money in
whatever is providing the best return right now. Just remember that all things in life have cycles. You may not be
able to predict when a cycle will begin or end, but you do know that it will. Rebalancing provides discipline to your
investment process and can keep you from making the big mistake of being late to the party and late to leave,
like the dot com investors of the last bull market.
Investment Wisdom
With the stock market in a late summer swoon, I thought some pearls of wisdom on the art of investing might take
your mind off the non stop "the sky is falling" gibberish on CNBC. I hope you enjoy these.
- If you see a bandwagon its too late. - James Goldsmith
- You only see who's swimming naked when the tide goes out. - Warren Buffet
- Individuals who cannot master their emotions are ill-suited to the investment process. - Benjamin Graham
- If investing is entertaining, if your having fun, your probably not making any money. Good investing is
boring. - George Soros - It's not the bulls and bears your need to avoid - it's the bum steers. - Chuck Hillis
- Sometimes your best investments are the ones you don't make. - Donald Trump
- I made my money by selling too soon. - Bernard Baruch
- We are all wrong so often that it amazes me that we can have any conviction at all over the direction of
things to come. but we must. - Jim Cramer - Don't bottom fish - Peter Lynch
- I measure what is going on and I adapt to it. I try to get my ego out of the way. The market is smarter than I
am so I bend. - Martin Zweig
Russian Roulette
Nick Murray is a well known figure inside the investment advisor community. He could be called an advisor's
advisor. A prolific writer with a dry style and laser sharp insight his monthly columns in Financial Advisor magazine
are greatly anticipated.
This past month Nick chose to discuss concentrated stock positions. He weaves an interesting story about one of
the bluest of blue chips, Merk. Noting that over the years Merk has been an excellent investment creating great
wealth for shareholders. But then on September 30, 2004 Merk announced that it was withdrawing the
blockbuster drug Vioxx from the market. You can remember the story from there. Fear of class action lawsuits and
memories of how asbestos decimated the building industry in the 1980s and how silicone implants crippled Dow
Corning came flooding to the public consciousness.
Merk opened down 27% the next day and eventually bottomed about 70% off its highs. Nick then coins one of the
phrases he is famous for: "You can get rich by under diversifying. But you cannot stay rich by under diversifying."
Wow! What a great way to sum up in a nutshell a lesson that could have saved millions of dollars for the
employees of Enron, Cisco, Sears, Xerox, and a host of past Wall Street darlings that eventually fell on hard
times. In fact, Nick likens overly concentrated stock holdings to playing Russian roulette with your financial future.
You may be okay today, "but tomorrow may be the day when the sun comes up on your Vioxx."
Nick's advise? "Sell every share you have to until that stock is no more than 20% of your net worth...and do it by
nightfall."
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