Reversion in Action

If you want to live a long and healthy life conventional wisdom says that you should eat in moderation and exercise regularly.

If you want to be a successful investor of common stocks conventional wisdom says you should spend lots of time analyzing companies or mutual fund managers and then try to pick the best ones.

That is mistake #1.

If you want to be a successful investor of common stocks forget about conventional wisdom and focus instead on reversion to the mean.

There are two ways to build long term wealth in the stock market.

One way is to be a lucky dog and pick stocks and mutual funds like a Western Gunslinger. Wall Street would prefer you choose this method of investing for obvious reasons. (C’mon, they’re not dumb).

The other way is to build a diversified portfolio with a clear understanding of the powerful force that reversion to the mean plays in the stock market and on your portfolio.

Reversion to the mean simply means that that 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.”

Visually we can look at it this way…

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.

Coffeehouse Investors call this “chasing performance.”

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.

Instead of trying to predict the random future, Coffeehouse Investors own ALL the sectors.

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