The bear market has hurt millions of investors. But in the end, is all the pain we're suffering merely payback for the stellar returns of past years? And will investors who stay the course be rewarded for their discipline?
One statistical theory argues that after a long period of strong performance, stocks can't avoid going through a bad period. Known as reversion to the mean, this theory seeks to explain the cycles of rising and falling prices that markets experience.
Paying the piper
In simplest terms, reversion to the mean says that when you compare a market's short-term results to its long-term historical average, you can guess which direction that market is likely to go in the future. After a period of outperformance, for instance, stocks are more likely to fall; after going through a down phase, stocks are more likely to rebound.
This month's brand-new issue of the Motley Fool's Rule Your Retirement newsletter discusses the reversion phenomenon and its impact on your retirement savings. Recently, investors have seen mean reversion play out around the world. Although U.S. markets have fallen sharply after a five-year bull market, international stocks in most foreign countries are down even more, perhaps marking the end of a long run of topping domestic stocks.
|
Country |
Year-To-Date Return |
|---|---|
|
United States |
(12.7%) |
|
Japan |
(15.2%) |
|
Germany |
(21.2%) |
|
India |
(36.5%) |
|
China |
(52.4%) |
Source: The Economist. As of Aug. 28, 2008.
Within sectors, mean reversion has been even more pronounced recently. While commodities stocks have pulled back from record gains, many companies in the financial sector have rebounded from precipitous losses:
|
Stock |
Return, 12/31/07 to 6/30/08 |
Return, 7/1/08 to 9/3/08 |
|---|---|---|
|
JPMorgan Chase |
(20.0%) |
17.0% |
|
Wells Fargo |
(19.7%) |
32.0% |
|
Fifth Third |
(58.1%) |
61.2% |
|
Potash |
59.0% |
(32.0%) |
|
Mosaic |
53.4% |
(35.6%) |
|
Freeport McMoRan |
15.4% |
(31.1%) |
|
Petroleo Brasileiro |
23.2% |
(32.2%) |
Source: Yahoo! Finance.
Having seen similar cycles in tech stocks and residential real estate, investors now commonly speak about bubbles inflating and bursting -- all as part of reverting to the mean.
Can you profit?
In the October issue of Rule Your Retirement, Foolish retirement expert Robert Brokamp speaks with renowned asset manager and author William Bernstein. When asked whether investors can take advantage of the mean-reversion phenomenon, Bernstein says it's indeed possible -- but, adding some words of caution, he also notes that you won't be right every time.
That advice certainly rings true with many investors. Although few people are surprised when an asset bubble ends, trying to time the end can be incredibly frustrating. As Keynes put it, the market can stay irrational longer than you can stay solvent -- and if you're wrong about when a market will revert to the mean, you can rack up bigger losses than you can handle.
But there's another reason why relying on mean reversion is dangerous. Because averages are necessarily based on historical prices, they can't take shifting economic fundamentals into account. If an industry is dying, the mean-reversion principle won't revive it. And if a particular sector or foreign market is poised for exceptional growth, then it can defy the mean for years -- and make truly amazing profits possible.
In general, though, mean reversion is one of many reasons why maintaining a well-diversified portfolio using asset allocation strategies makes sense. By keeping your money in a variety of investments, you'll help balance out the inevitable ups and downs across your portfolio and keep a more even keel as you move toward your financial goals.
