When one speaks of “regression toward the mean” (average) they are speaking of the the phenomenon where an extreme measurement tends to move closer to the average upon successive measurements. As an investor, why should this concept interest you? How can it help you to be a better investor?
Doing justice to this concept within this blog post is not possible. Therefore, I seek to only drive home the most important points that will benefit investors. Regression towards the mean deals with extremes and how extremes are hard to maintain – especially to perpetuity. Tall parents may lead to taller children, but throughout successive generations limits are realized. If this wasn’t the case, we’d have 11′ tall people walking around. The same can be applied to investments. While many investments will rise or fall, they will have a more difficult time maintaining such a direction in the long-term.
Stocks that continue to rise and rise some more will meet greater and greater resistance as they move forward, all else being equal. If no ground breaking news, good or bad, is to break, the stock will eventually move back to the mean. Think of industries for a moment. Industries will be over-hyped or beaten down from time to time, but that does not mean that is their permanent home. Far from it. An industry that is overvalued or undervalued will have a difficult time maintaining such a position, unless something actually changes to cause their valuation to change (where the mean resides). If the mean (average) moves then the notion of ‘extreme’ moves.
As an investor this concept should make you think more about those industries and/or specific stocks that trade at/near a 52 week high or at/near a 52 week low. Why are they trading at such levels? Is such a price movement an extreme reaction by the market? Or has new information changed the reality for that industry/stock so that its current price is not really at an extreme? If the situation aligns with the former (truly extreme), then consider the regression to the mean phenomenon. In the long-run you’ll be rewarded.
Two industries I see today that might be in the process of regressing back to the mean are the shipping and natural gas industries. Almost across the board, shipping has been beaten down since the recession started in 2008. The market’s perception of shipping is filled with bears, but are they overly bearish? Are things as bad as they are perceived by the whole? I tend to think the pendulum has swung too far to the negative side. Secondly, regarding natural gas, the resource has not seen the upswing in prices that other natural energy resources have, such as oil. Thinking long-term , are investors bullish enough today on natural gas given what we currently know and its implications for the coming years?
Regression towards the mean is a powerful concept for investors. Though it is powerful, it is not necessarily the golden ticket to a successful investing strategy. It is only one piece of the puzzle, but an important piece that should be considered every time you are sizing up an investment.