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  • Writer's pictureWiseWallet

How to Guide Your Investment Using the Concept of Mean Reversion

We introduced various ways to help guide your investment journeys in our previous blog posts. For example, we explored how behavioral economics can help you save more for investing. We introduced how to ride a bull market as a long-term investor. We also discussed our proven strategies to navigate market downturns. Recently, we shared two concepts in behavior economics that will help you overcome irrational behaviors in volatile markets.

 

What? - Understanding Mean Reversion in Investing

 Mean reversion is a fundamental statistical concept in finance that explains why extreme performances—either high or low—are usually followed by returns to more average levels. This phenomenon occurs because outliers or unusual results often balance out over time. For instance, if a stock performs exceptionally well for a period, it is likely that its performance will revert to its historical average sooner or later. Conversely, stocks that have underperformed may also see better performance as they revert to their mean.

 

So What? - Why Does This Matter for Investors?

Investors often get caught up in the excitement of stellar performances or panic during significant declines, making decisions based on short-term trends. Understanding mean reversion can provide a more balanced perspective:

 

  • Avoid Overestimating Future Performance: Stocks or sectors that have seen extraordinary gains are not guaranteed to continue on that trajectory. The provided chart illustrates this concept well. For example, META (formerly Facebook) has experienced periods of both underperformance and overperformance compared to the Technology Select Sector SPDR Fund (XLK), a sector benchmark index. These fluctuations highlight the importance of not making investment decisions based solely on recent performance.



  • Better Investment Timing: The chart shows clear periods where META's performance deviates significantly from XLK. Investors who recognize these deviations can make more informed decisions about when to enter or exit positions. For instance, buying META during periods of underperformance relative to XLK could potentially lead to gains as it reverts to the mean, while selling during periods of overperformance can help lock in profits before a potential regression.

 

  • Risk Management: By anticipating that high-performing investments might return to average levels, investors can avoid placing undue risk on what appears to be a "sure thing." This is crucial in constructing a diversified portfolio that balances potential returns with acceptable risk levels.

 

  • Realistic Expectations: Mean reversion helps temper expectations. For instance, during the housing boom before 2008, property prices soared only to regress significantly during the market crash. Investors aware of mean reversion would have been cautious of unsustainable growth.

 

Now What? - Applying Mean Reversion in Your Investment Strategy

  • Diversify Your Portfolio: Spread your investments across different asset classes and sectors to mitigate the impact of mean reversion in any single investment.

  • Regular Rebalancing: Periodically rebalance your portfolio to maintain your desired asset allocation. This process inherently takes advantage of mean reversion by selling high-performing assets and buying underperforming ones, keeping your portfolio aligned with your long-term strategy.

  • Avoid Emotional Decisions: Use mean reversion as a reminder to stay rational during market highs and lows. When stocks like META or entire sectors like technology surge, it's tempting to assume continued growth. However, remembering that extreme performances often revert can help in making more grounded investment decisions.

 

Concluding Remarks

Mean reversion is a powerful concept that can guide investors in maintaining a balanced and realistic approach to investing. By understanding and applying this principle, you can avoid the pitfalls of chasing short-term gains or fleeing from temporary losses, ultimately leading to more stable and potentially more profitable investment outcomes over time.

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