Investing Lessons from Mean Reversion

Mean Reversion is a mental model from the field of statistics. It says that an event that is not average will be followed by an event that is closer to the average. Mean reversion, also known as Regression to the mean, is exhibited by all random events. The intensity with which mean reversion affects an activity is directly proportional to the element of luck controlling the outcome in that activity. So activities like swimming and chess, where luck plays no role and the outcome is determined by skill, mean reversion doesn’t occur.

Mean Reversion has strong implications in stock market. As a result periods of above average performance are usually followed by below average returns and periods of below average performance are typically followed by above average returns. Which means, in selecting a mutual fund, because of Mean Reversion, you shouldn’t go just by the outcome i.e., fund performance. The trick is to look at the process that leads to the outcome.

The second trick for dampening the effect of mean reversion is to take a bigger sample size. Which means you shouldn’t rely on short term performance records. If you are looking at ten year performance figures of a fund then odds are high that the fluctuations introduced by randomness and luck have evened out over long term and what you see is a reasonable proxy for fund manager’s skill.

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Books mentioned in the video:
Thinking, Fast and Slow by Daniel Kahneman -http://amzn.to/2cudC5D

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