This article appeared first on The Stock Market Blueprint Blog.
By studying the long-term performance of professional sports teams, investors can gain a sense of a stock’s future returns. Mean reversion controls stock market returns as much as the outcome of sports competitions.
It’s easy for sports fans to assume a championship team will continue its stellar performance into the next season. It’s equally easy for investors to extrapolate a stock’s recent performance into the future.
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It’s often assumed a winning stock will keep rising and a losing stock will keep falling. The reality is that back-to-back championships are rare occurrences, and all stocks turn around eventually.
Super Bowl XLIX
On February 1, 2015, the Seattle Seahawks were competing to win the Super Bowl for a second straight year. On 2nd & goal from the one yard line, the Seahawks were down by four points with 27 seconds left in the game.
The only thing standing in their way from becoming back-to-back champions was the New England Patriots defense. In what immediately became one of the most controversial play calls in sports history, Seattle’s QB Russell Wilson took the snap and threw a quick slant to WR Ricardo Lockette in the end zone.
In the spilt second after the ball left Wilson’s hand, Patriots’ DB Malcom Butler stepped in front of Lockette and intercepted the pass. Butler’s amazing play crushed the Seahawks chances of being only the ninth team ever to win the big game two years in a row.
Although it’s most likely no consolation to Seahawks fans, being only one yard away from holding the Lombardi trophy in consecutive seasons is a highly improbable accomplishment. Only eight teams in the last 50 years have been able to hold onto the title of Super Bowl champs for two straight years.
Great NFL teams have a hard time remaining great due to a phenomenon called mean reversion.
The mean reversion hypothesis says that over time, results of any kind will move toward an average. Tobias Carlisle, in his book Deep Value, quotes Michael J. Mauboussin’s explanation of mean reversion’s effects on anything in the natural world:
“The basic idea is outstanding performance combines strong skill and good luck. Abysmal performance, in contrast, reflects weak skill and bad luck. Even if skill persists in subsequent periods, luck evens out across the participants, pushing results closer to average.”
This is the same universal wonder that Nobel Prize winner Daniel Kahneman came to understand while speaking to a group of flight instructors. Carlisle recounts a time Kahneman was confronted by an instructor regarding the effectiveness of punishment over praise. After Kahneman mentioned that praise was more effective, an instructor countered with the following:
“On many occasions I have praised flight cadets for clean execution of some aerobatic maneuver, and in general when they try it again, they do worse. On the other hand, I have often screamed at cadets for bad execution, and in general they do better the next time.”
It instantly became clear to Kahneman that the reversal in flight performance had nothing to do with praise or punishment but was the result of mean reversion.
The Stock Market
Mean reversion is just as much a factor in economics and public markets as it is in sports outcomes and flight performance.
In business, this implies that a company that is currently earning abnormally high or low operating profits will eventually produce results more in line with historical norms. Another quote from Deep Value is Benjamin Graham’s warning that business results don’t last forever:
“Abnormally good or abnormally bad conditions do not last forever. This is true of general business but of particular industries as well. Corrective forces are usually set in motion which tend to restore profits where they have disappeared, or to reduce them where they are excessive in relation to capital.”
Investors in the stock market tend to ignore Graham’s wisdom in the above quote and irrationally overreact to “good” or “bad” conditions. This causes stock prices to at times stray far from the underlying value of the companies.
Not only does mean reversion state that a business’s profitability will return to normal, it also implies that mispriced stocks will eventually align with what the business is worth. Investors can be certain that the underlying value of a company will be the ultimate factor in a stock’s price.
It should be reassuring to know that no matter how wildly stock prices swing, they will inevitably revert towards the company’s fair value.
Mitchell Mauer is the Founder of TheStockMarketBlueprint.com. The Stock Market Blueprint is a site that finds value stocks for investors building long-term wealth. The site’s investment philosophy is anchored in principles established by Benjamin Graham and his most reputable followers over the last 100 years.