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What do you make of statements like Warren Buffett’s advice to “be fearful when others are greedy, and greedy when others are fearful”? Or Baron Rothschild’s “the time to buy is when there’s blood in the streets”?
How about former Fed Reserve chief Alan Greenspan’s “irrational exuberance”?
These statements all share a common concept, something that most of us possess in our deep thinking, commonsense brain, but sometimes forget amid the short-term noise. These pearls of wisdom all rest on the assumption that mean reversion will ultimately prevail.
Famed investor Warren Buffett’s advice is to “be fearful when others are greedy, and greedy when others are fearful”.Credit: AP
In the short-term market, returns are quite random. We can see this in returns for the Australian sharemarket over the past few years. In the 2022 financial year, the Australian market was down 7.4 per cent. The year before it was up 30.2 per cent. And the year before that it was down 7.2 per cent. All over the shop.
Yet when you zoom out and consider the average return, whether you look at 20, 30 or 50 years, you see a return inclusive of dividends of about 10 per cent per year.
To grasp the concept of mean reversion, consider this long-term average to be a magnetic force. When market returns are unusually low, the mean reversion magnet tends to pull returns up. In reverse, when returns have been unusually high, the mean reversion magnet tends to pull returns down so that the long-term average continues to prevail.
When we invest, we all want to see growth. As long-term investors, we know that there are often periods of weakness that we need to endure. The concept of mean reversion is a useful way to help you stay the course. Ultimately, the long-term average return will prevail.
A year or two of poor returns will require some above-average returns in subsequent years to square the ledger and balance things out. This idea is consistent with the concept of cycles that we see across the economy. Our economy goes through a buoyant period of strong economic growth, profitability, and employment. But at some point, it gets too much and there’s a bust that sees everything slow.
Roll forward a few years and optimism slowly regains ascendancy, pushing us into the next period of growth. Mean reversion in investment markets, and economic cycles, are very much close cousins, not necessarily in their timing, but in their operation.
Mean reversion is not so useful at the individual company level for long-term investors. A company’s share price might drop as it heads towards bankruptcy. No mean reversion magnet is going to pull that price back up to a long-term average once the company goes out of business. On the flip side, a strongly growing company may very well have a constantly growing share price reflecting its increased profits over time.
Mean reversion is probably an idea you had in your brain but didn’t have a name for, but it’s an idea well worth keeping in mind. When markets are booming, recognise that at some point the wheel is going to turn, with some inevitable poor years. And likewise in the midst of weak markets, console yourself with the knowledge that the forces of mean reversion will ensure that long-term investors like you are appropriately rewarded. All it takes is patience.
Paul Benson is a Certified Financial Planner, and host of the Financial Autonomy podcast.
- Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. Investors should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.
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