Reversion to the Mean

There is a concept in investing that for me has been a bit of a light bulb type moment. It refers to reversion to the mean. What does that mean you may ask (or for you more experienced investors you may ask what has taken me so long to turn on to this!):

A theory suggesting that prices and returns eventually move back towards the mean or average. This mean or average can be the historical average of the price or return or another relevant average such as the growth in the economy or the average return of an industry.

I think about it by using an example of people’s weight loss. Many times you will see people (me included) who have gone on a diet to lose a whole bunch of weight only to gain it all back only a short period later. Many of these people have spent a good part of their lives at the heavier weight and for them the heavier weight is their “mean” or “average” weight. To me what is happening here is the body is simply returning to where it has always been when that weight starts to pile back on.

I believe that stocks do this as well. There will be periods of time when the share price of a stock will be much higher (as judged by the P/E ratio for example) than its average price has been for a certain period of time. Buying stocks when they are showing signs of being below historical averages is really what is being referred to when you hear the term buy low, sell higher. For a really good description of this in action, please check out the BMW Method.