Mean Reversion and Managing Market Jitters

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Anyone who has sat through a statistics class has been exposed to the term “reversion to the mean,” or, as it’s often called, “mean reversion.” Even if you’ve never cracked a stats textbook, the basic concept is easy to understand: reversion to the mean refers to the statistical tendency of extreme or unusual results to be followed by more typical or average results over time.

Most of us understand this tendency intuitively. When meteorologists refer to “average temperatures,” for example, we understand that some days will be hotter than average, some will be cooler, but over time, daily seasonal temperatures will tend toward an average number. Similarly, in the financial markets, the prices of certain assets may go up or down by an unusual amount in a given period, but over time, their rate of return will move toward its average. So, if prices rise dramatically in one year, they may have a tendency to rise by a lesser amount – or fall – in the next year. Viewed over a long enough time, however, the variances will tend to flatten out, and we are able to discern an average. This process of “flattening” is the essence of reversion to the mean.

The problem for advisors comes when investors react to asset price movements that are well outside the “average.” This often leads to impulse-based financial decisions that are typically detrimental to the client’s long-term interests.

With an understanding of reversion to the mean, however, it is possible to contextualize market volatility for investors in a way that helps them view it more constructively.