Reversion To Mean
69% of the time it works every time
Reversion to mean is a fancy way to say things tend to come back to the average.
To put it in sportsball terms, imagine a career .250 hitter in baseball who is 100 games into the season and batting, again, right around .250. The guy has finished every season of his career right around .250. (For non-baseball fans, .250 is ‘meh’ and means gets on base ~25% of at-bats and 100games is a little over half-way through the baseball season. In short, incredibly consistent batter).
Suddenly he goes on a tear and over a 5 game stretch he gets on base 15/20 times (.750) hitter.
How much would you be willing to bet in the next game he plays he goes 1 for 4 at the plate?
How much would you be willing to be he goes 3 for 4?
You probably don’t know. Hitters go on hot streaks and they can last for weeks. Hitters also go on cold streaks where they can’t seem to get on base.
However, you would probably feel pretty comfy betting that by the end of the season the guy probably finishes up right around .250 again. That has been his batting average for his whole career and how he was trending again this season. A little hot streak 100 games into the season probably gets offset by a little cold streak at some point in the future where he is batting less than .250.
[Note 1 - Batters usually get 3-5 at-bats a game. So call it 4. That means 100 games into the season he has around 400 at-bats (ignore walks which don’t count for now). To be batting .250, it means he got on base 100 times in 400 at bats. His 5 game hot streak puts him at 115 on bases in 420 at bats or .273. Maybe he only gets 10 hits in his next 80 at-bats to get back to .250]
[Note 2 - if you don’t follow baseball and prefer football - think of a running back who averages 100 yards a game for his career who suddenly goes off for 250 yards one game, or an NBA player averaging 10 points a game who puts up a few 30 point games in a row. ]
Anyway, the point is, if something has consistently and over a long-period of time had a steady average, then a short-term high or low is likely offset to return (aka revert) the long-term number back to the average…assuming no major change in the underlying thing.
Reversion to mean is a hard rule. Sometimes things do break out. Often this is driven by some fundamental change, but not always.
But it is a common enough phenomena that you should be aware of it.
Bringing this back to finances, reversion to mean has been on the mind when it comes to the stock market. And when the market returns a string of well above historical average returns it usually means one of 3 things: 1) A correction is coming, 2) Future returns will be lackluster even if positive, or 3) there has been a fundamental shift in the underlying markets/economy.
This post will breakdown each possibility and help you make a plan.