Reversion To The Mean Phenomenon: Part IV

Includes: DIA, IWM, QQQ, SPY
by: Larry Swedroe

This final post of the RTM series will explore the importance of discipline. The academic evidence demonstrates that the determinant of almost all of the risk and return of a portfolio is its asset allocation. It's important to add that because of recency, the most important determinant of the return that an investor's portfolio actually produces might be the ability to adhere to whatever the asset allocation the investment policy statement called for. In other words, discipline to adhere to a plan can be more important than the plan itself.

Wise investors know that while reversion to the mean is a powerful force, trying to trade on that information in order to generate excess returns is a loser's game. One reason is that streaks of abnormally low or abnormally high returns can continue for a long time. The following insightful quote has often been attributed to John Maynard Keynes, perhaps the most famous economist of modern times: "The market can stay irrational longer than you can stay solvent."

Let's look at some further evidence on trading strategies based on market valuations.

Statistical Relationships and Trading Strategies

Studies have found that when the spread in book-to-market (BtM) ratios between value stocks and growth stocks is high, the subsequent value premium tends to be high. The reverse is also true. Based on that information, if next year's value premium is expected to be high, it would seem logical to own value stocks. If it is expected to be low, then growth stocks become the logical choice. Is it really that simple to earn abnormal returns? Does a statistical relation always translate into a viable portfolio strategy? These are the questions Jim Davis asked and answered in his study "Does Predicting the Value Premium Earn Abnormal Returns?" The study covered the period July 1927-June 2005.

Davis found that style-timing rules did not generate high average returns despite being able to use future information about BtM spreads. In fact, he concluded that the expected excess return of style timing is probably negative. The lesson for investors is that just because a statistical relationship exists doesn't necessarily imply that a profitable trading strategy based on that relationship exists, especially after taking into account trading and other costs.

The same thing is true for stocks. Just because P/Es or the CAPE 10 is above average, doesn't mean that you should sell stocks and move to safe bonds. While valuations might be high, that doesn't mean that there isn't an ex-ante equity risk premium. In fact the CAPE 10 was well above its long-term mean for almost the entire period 1991-2007 and the S&P 500 returned 11.4 percent a year, 1.3 percent a year above its return of 10.1 percent from 1926-1990. Investors waiting for the CAPE 10 to RTM would have missed out on those strong returns.

The bottom line for investors is that the prudent strategy is to adhere to your investment plan. However, that doesn't mean doing nothing. It means both rebalancing as needed and tax loss harvesting as the opportunities present themselves.

The Winning Strategy

The winning strategy includes disciplined rebalancing. Rebalancing is the process of eliminating the style drift caused by the market in order to restore your portfolio to its original asset allocation. For example, consider a portfolio that consisted of only the two asset classes we have been discussing, U.S. large-cap growth stocks and REITS, and allocates half to each. During the period 1995-99, when large-cap growth stocks were returning 31.3 percent, REITS were returning just 8.3 percent. Disciplined investors would have been doing the following: At the end of each year (except 1996 when REITS outperformed large-cap growth stocks), they would have sold some of the large-cap growth holdings and increased their REIT holdings in sufficient quantities to restore their desired 50:50 allocation. The reverse process would have occurred in every year from 2000 through 2006. They would have been selling some of their REIT holdings and increasing their large-cap growth holdings. In each case they would have been "leaning against the winds of emotions" (and recency). In other words, they would have been buying relatively low and selling relatively high - a much better strategy than the one that results from being subject to recency.

The bottom line is that disciplined rebalancing, restoring your portfolio to the asset allocation you decided was the most appropriate when you developed your carefully thought-out plan, is the winning strategy. And remember that high returns lower future expected returns, and vice versa.


What lessons can we take from this series? First, above (below) average returns generally are accompanied by rising valuations, which then predict lower (higher) future returns. That's why there is such a strong belief in reversion to the mean of returns. With that said, we don't know that the long-term mean valuation (P/E or CAPE 10) is a mean to which we should expect valuations (and thus returns) to revert. Changes in a country's wealth, regulatory environment, accounting rules, and dividend polices make it difficult to make apples-to-apples comparisons. And that makes drawing conclusions about the market very difficult.

The one thing that most financial economists do agree on is that the current level of valuations does forecast lower than historical returns for stocks, quite a bit lower. Thus, investors who are using historical returns to project a 7 percent real return to stocks are likely to be disappointed, and run the risk of falling well short of their financial goals. Most financial economists are forecasting real returns more in the area of 3.5 to 5 percent - and even that return assumes no RTM of valuations. Thus, you should be sure that your plan incorporates this likelihood and also the possibility that valuations could RTM. And if that were to happen quickly, Jeremy Grantham would have his wish and stocks would experience a severe bear market. However, if it happened only gradually, say over a 10 or 20 year period, real returns could be only somewhat lower than the "consensus" of a real return of 3.5 percent to 5 percent.

>>Part I

>>Part II

>>Part III

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.