It Is a Confounding Reality That Stock Prices Revert to the Mean

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It’s not just Robert Shiller who says that stock prices revert to the mean. John Bogle said that in his book Common Sense on Mutual Funds. Bogle described reversion to the mean as an “iron law” of stock investing.

People don’t question that this is so. Even confirmed Buy-and-Holders do not question it. They should. If they accept that reversion to the mean exists, then they should accept that market timing is required. The one thing follows from the other.

Do Stock Prices Revert To The Mean?

The widespread belief that stock prices revert to the mean is not intuitive. Most people believe that the market sets stock prices through a rational process, that all of the economic developments of the day are taken into consideration by millions of investors and that prices are recalibrated and set in their new proper place.

If that were the reality, the mean stock price (a CAPE value of 17) would have no significance. Each day of stock pricing would be independent of all the others. What happened at earlier times would tell us nothing about what the stock price should be today.

But it clearly does. Bogle was the king of Buy-and-Hold. He was disdainful of market timing (in fairness, he softened his view a bit in some comments that he made as part of a long-running debate on safe withdrawal rates that I started way back in 2002).

The objection to market timing is that no investor can know better than the market where prices should be. But that is clearly not so if reversion to the mean applies.

All that the investor needs to do is to take note of how far from the mean the current price is. He can safely predict the direction in which prices will be headed in the long term and the strength of the pull that will be felt in that direction.

Stock prices are predictable! That’s what Shiller is saying when he says that stock prices revert to the mean. That’s what Bogle was saying when he said that stock prices revert to the mean. That’s what anyone who says that he believes that reversion to the mean applies is saying.

The Conditions For Reversion To The Mean

Okay. Here’s the hard one. Why does reversion to the mean apply? Why isn’t each day of stock-price-setting an independent event? Why is it that the market has a memory?

It’s because investors are not 100 percent rational, as was presumed by the people who developed the Buy-and-Hold concept back in the 1960s. If investors were engaged in the rational pursuit of their self-interest, they could just do that anew each day with no thought of what they had done at earlier times.

Investors are not engaged in the rational pursuit of their self-interest. Investors are humans. Which means that their emotions influence their decisions, rationality and self-interest be darned.

We all want our stock portfolio to be bigger than what the economic realities dictate it should be. So we tell ourselves all sorts of stories justifying higher stock prices and then act in accord with those stories rather than the economic realities when setting stock prices.

While we are doing that, we retain our ability to engage in rational thought. It makes us uneasy to set prices improperly. All the while that a bull market raises prices, we have a thought in the back of our mind that a bear market is coming and that we want to be first to get out of stocks when it does.

So the conditions for reversion to the mean are always in place. We set prices at one place while carrying the knowledge that we are setting them at the wrong place. Reversion to the mean is just a process by which the two conflicting thoughts resolve on the world stage over the course of time.

Stock prices don’t need to change as much as they do. We now have research available to us showing that market timing is required and that we could obtain higher returns at less risk by choosing a more rational approach to stock investing.

As a society, we have not yet given ourselves permission to discuss that research openly because it scares us to see how irrational we have been and we worry that seeing that will cause the bull market to collapse (which of course is a legitimate worry).

But I believe that, after prices fall, we will come to terms with what the recent research is trying to teach us and will become better able to rein in our Get Rich Quick/Buy-and-Hold inclinations. The more rational stock investing becomes, the less prices will travel from the mean and the less mean reversion we will see.

Rob’s bio is here.