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Mean Reversion: Your Portfolio's Secret Ingredient

Your inner contrarian may be no fun at parties, but could be your best friend when investing

Morningstar ETF Analysts 26 April, 2010 | 0:00

Investors are always looking at fund flows to spot the latest trends in the market, whether it's a hot sector or a fallen star. This information gives us insights, and highlights one of the most common mistakes investors make--over-emphasising recent performance. Funds or sectors that post market-beating returns often see inflows ramp up as everyone hopes the hot streak will continue, just as shareholders typically bail out of laggards after a period of poor performance. Unfortunately, this behaviour usually leads to worse long-term returns than just buying and holding, as yesterday’s prince is often tomorrow’s frog. Your inner contrarian may be no fun at parties, but could be your best friend when investing.

This leads us to the concept of mean reversion, the secret ingredient that makes the boring formula of balanced portfolios and periodic rebalancing so successful. In its most basic form, mean reversion refers to the tendency of extreme performers (on either the high or the low end) in one period to perform the opposite in the future, bringing their long-term results closer to average. Mean reversion of prices to a long-term stable growth rate is one of the few predictable properties of nearly all asset classes. A quick online search for 'mean reversion' shows how many academic dissertations have been minted by finding this phenomenon in a new financial niche. Though the mechanisms behind long-term mean reversion are complex and imperfectly understood, the concept is quite perfectly simple. After a quick glance at the theory, we'll walk through two fairly straightforward examples of this principle in action, and then let you know how to put this theory into practice when managing your portfolio.

There are a number of possible explanations put forward for mean-reverting returns, but the most common is investor overreaction. In the face of imperfect information, investors look for the sectors, regions, or companies that have the rosiest prospects. These will often be the same assets whose price has been rising fastest in recent years, confirming the positive story. So far, so good. Unfortunately, investors seem to extrapolate that same past success on into the future, which is much less likely. The best-performing stocks all have good stories, but they also probably had a strong dose of good luck in the form of low competition or a fast-growing customer. As the tailwind from that lucky break dies down, disappointed investors pull out their money and future returns fail to match the past. Meanwhile, the woe begotten losers of yesteryear have shaken off their crippling debts, or used up their spare capacity, and look primed for strong returns. This type of mean reversion helps drive the “value effect”, where assets with low past returns and low prices relative to fundamentals tend to outperform.

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About Author

Morningstar ETF Analysts  research hundreds of ETFs available to European investors. The Morningstar Rating for ETFs is based on a risk-adjusted performance measure

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