Regression To The Mean And Why Investors Should Not Ignore Its Importance

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Includes: CYNK
by: Altitrade Partners

Summary

High stock prices, low interest rates and non-existent volatility have lulled investors into a false sense of security.

Avoid the temptation to extrapolate events of the immediate past into the indefinite future.

What the mania of Cynk Technology's stock tells us about investor psychology.

If there's one thing that I've learned over the past three-plus decades as an investor, it's that nothing lasts forever. Not bull markets. Not bear markets. Not high interest rates. Not low interest rates. Not periods of extreme volatility. Not periods of diminished volatility. Nothing -- I mean absolutely nothing -- lasts forever.

Every market goes through some kind of natural progression of prices moving up (as demand outstrips supply) and prices moving down (as supply overwhelms demand) and then, ultimately, returning to some semblance of normal pricing (where supply and demand counterbalance each other), that is, if there is any such thing as normal pricing these days in the markets. Richard Russell, the famous Dow Theorist, once noted that over a shorter time frame almost anything can happen in the financial markets, but over much longer, meaningful periods of time (referring to years), the surest rule in the stock market is the rule called "regression to the mean."

It seems that investors have forgotten just how important this statistical principle is in today's market environment. Human nature finds it much too easy to dismiss regression to the mean, but those that do will ultimately find that this rule of statistics cannot be ignored forever.

Human nature finds it hard to resist the temptation to extrapolate events of the immediate past into the indefinite future. We tend to discount those things and events that occurred over the intermediate (and longer) periods of the past, and focus our thinking on what is happening in the present days, weeks or months. In essence, we suffer from having short memories when it comes to the financial markets.

In the context of this idea that "nothing lasts forever," along with the propensity of investors to give little thought to the importance of "regression to the mean," we would like to offer the following for your consideration. One of the inherent flaws of human nature, when it comes to making investment decisions, is an apparent inability to fully factor in past historical tendencies into present and future thinking. Here is where the results of the immediate past are extrapolated into the indefinite future, and the intermediate to long-term tendencies are ignored. We know that they are there, but we chose to ignore them anyway.

No doubt, fear and greed play an important part in this so-called blocking mechanism, but that is a topic for another place and time. The best example that I can use, to illustrate this concept, happened just this past week. An unknown little technology company called Cynk Technology (OTC:CYNK) suddenly bursts onto the investment scene. Investors are intrigued with the company, despite there being little known information about the company's business, past results, and future prospects.

In fact, there was even some question about whether the company even existed at all? The company had no revenues, $39 in assets, and approximately $52,000 in liabilities, according to recent financial documents and filings. What happened next was truly amazing, and mind-boggling. Despite all of the red-flags that were out there in plain sight, investors piled into the stock at an alarming rate. The price of the stock went from just $0.06, on June 16, to over $20, intraday, in less than four weeks.

We put a post on our Facebook page that said "Shades of the 2000 tech bubble? As Yogi Berra would say, it's déjà-vu all over again." Yes, the great technology bubble of the late 1990s, which burst in March of 2000, was being played out all over again in this one tiny little technology stock.

In that great investment mania, which ended very badly for many investors, all you had to have was a name with a dot-com at the end of it. You didn't need revenues, or an experienced management team, or even a business plan for that matter. All you needed was an idea and a web site, and investors would flock to purchase your stock.

The prices of many of these start-up technology firms went through the roof, along with their market valuations, and we were on our way to a "new paradigm." Things really were "different this time," in the eyes of many investors. Or were they? Back then, we didn't know the answer. Today we do.

In terms of CYNK, why did so many investors ignore what was essentially a return to the dot-com bubble mentality? How could they so blatantly ignore the signs that became apparent after the great tech bubble burst at the beginning of the new millennium? The answer is human nature. Our memories, when it comes to investing, are selective. Our current decisions are based on whatever filters we create to let information in, or keep it out.

In some cases it's a defense mechanism. How many times have you found yourself justifying a bad investment position because you cannot accept the idea of being wrong? Your mind only allows you to have those thoughts that support your choice.

We think that today, there is a similar pattern taking place among investors. High stock prices, low interest rates and non-existent volatility are expected to last forever. Well, I can tell you with absolute certainty that they will not! There are too many historical markers along the road called Wall Street that indicate that we are nearing a critical juncture in the stock market.

You can continue to remain fully invested, ignoring the many signposts which may be saying we could be nearing the end of this phase of the bull market, or you can take a step back and assess where we are from the standpoint of history and ask yourself do I really want to ignore one of the most reliable and surest statistical principals ever devised for avoiding the directional extremes of the markets?

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.

Disclaimer: The opinions expressed herein, are exclusively those of Altitrade Partners. We do not provide investment advice, and do not offer buy and sell recommendations on any securities mentioned in our reports. For additional information, including our full disclaimer, we invite you to visit Altitrade Partners.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.