That’s one mean reversion!

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If historical 10-year average cycles are any predictor, now is not the time to abandon long-term strategies (see chart).  The response to excess in the form of the dot-com-bomb and the credit-crunch-chaos caused the last 10 years to be one of the worst in U.S. history.  However, notice that weak 10-year periods always overshoot the mean, and are often followed by strong recoveries (i.e. your friend, “reversion to the mean”).  Successful long-term investors develop perspective and “market memory” and learn to expect, but not predict market swings.

It is both comforting and disappointing to know that statistics can be simultaneously valuable and meaningless.  With the dubious pride of a front-page tabloid journalist, many a college statistics professor has quoted Mark Twain’s statement that “There are three kinds of lies: lies, damned lies and statistics.”

Fortunately for our clients, Madoff-style “lies and damned lies” are not a concern, but statistics are a foe… and friend.  Madoff was just plain mean, but in statistical jargon, “mean” means “average,” and “mean reversion” refers to the tendency of events, such as investment performance, to become “normal” over time. Stated simply, extremes, whether high or low, are only temporary.  No one hopes for a mean reversion after an extended strong market, but a return to the average would certainly be welcomed right now!

The chart below illustrates the market’s significant yet unpredictable cycles, gyrating around a fairly static long-term average. The response to excess in the form of the dot-com-bomb and the credit-crunch-chaos caused the last 10 years to be one of the worst in U.S. history.  However, notice that weak 10-year periods always overshoot the mean, and are often followed by strong recoveries (i.e. your friend mean reversion).


Enough statistics, where’s the wisdom?  Successful long-term investors develop perspective and “market memory” and learn to expect, but not predict market swings.  They design portfolios around goals rather than greed, rebalance as a risk-control, and don’t take more risk than is needed to achieve their goals.  In fact, wise investors reduce their risk, strategically, when they are ahead of their goals after strong markets.

 

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