In my last post, I discuss what happens when the valuations of large companies are driven to unsustainable levels and end up retreating to market-level valuations, otherwise known as “reversion to the mean.” Ignoring this investment concept can often lead a beginner or even the most experienced investor, astray.
I dedicate an entire website page to this concept because I want investors to understand the relatively basic idea of what goes up is likely to come down, and that what goes down is likely to bounce back, in other words, it “reverts back to the average.”
Here’s a visual to explain the idea:
It is at this point, when C is outperforming the average and A is underperforming the average, that many investors sell A in favor of C.
Reversion to the mean causes lots of problems for lots of investors because almost everyone begins by choosing A, that is, they choose a mutual fund or a sector with a good track record.
Then, when A reverts to the mean, or goes underwater, these same investors must decide whether to hang on to the underperforming A or switch to C.
Most people invest in sectors or mutual funds that have had a good track record (after all, that’s the most logical way to choose mutual funds). Unfortunately, because of the powerful force of reversion to the mean, investors inevitably become disappointed with their selection and are on to the next hot fund or sector.
If you want to be a successful investor of common stocks, forget about conventional wisdom and focus instead on reversion to the mean.