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Regression to the Mean will Happen

MJG
edited July 2016 in Fund Discussions
Hi Guys,

I wish you all a happy and safe Independence Day. I will definitely overeat.

On recent posts some considerable concern has been expressed over the current length of several zero returns delivered by indices like the S&P 500. I don’t share that concern.

It is not a rare happening. In a very rough measure, it occurs something like one-third of the time based on long term market history. Not to worry because a regression-to-the-mean is always operative. The data support this observation. Here is a Link to a recent article by excellent financial writer Morgan Housel that reviews that data:

http://www.fool.com/investing/2016/06/30/when-stocks-give-you-nothing.aspx?source=iaasitlnk0000003

Housel subtitled his piece: “the long wait”. That’s appropriate. Patience can be severely tested. The quandary for investors is that nobody can forecast how long that wait is and when it will end. But be confident that it will end. Figure 2 in the Housel article illustrates the potential length of that long wait from historical data.

Nobody likes running in-place, but a regression-to-the-mean will eventually kick-in. Unfortunately, not any expert can predict when that will happen in a reliable, reproducible manner. That’s the nature of the equity marketplace. But as the zero return environment lengthens, the odds of a recovery to the historical average annual returns increases.

I completely agree with Housel’s observations that patience and a cash reserve are mandatory requisites for successful investing. Incrementally increasing your equity positions during this difficult period will surely not maximize your total end wealth since only precisely picking the market bottoms can do that. But that’s an impossible goal; it can not be done.

In that sense, investors should be satisficers and not maximizers. There just are too many fund choices and too much uncertainty to ever fully realize maximizer perfection. Any attempt to do so will ultimately end in unhappiness at our failures to accomplish that lofty target. Instead, being satisfied with near Index returns is easily accomplished with little effort and even little time commitment. I practice that discipline.

The percentage of professional money managers who successfully maximize returns, using an Index as a measure of their success, is grimly low. The evidence is in their dismal performance records.

Please enjoy the fireworks and the feasting.

Best Regards.

Comments

  • What caught my eye was: "adjusted for inflation", which says that the figures are for 0% real returns. The recent concerns have been over 0% nominal returns. That's a less frequent occurrence (since inflation is almost always positive).

    "Regression to the mean" says that since a 0% return is below the market average (mean), you're more likely to get a positive return (regress to the mean) than a negative return (diverge further from the mean) over the next time period.

    It doesn't say that your cumulative returns will approach average if you wait long enough. That's the law of large numbers. And the further your returns are from mean, the larger (more years) those numbers have to be to get close.

    The concern when the market underperforms (or outperforms for that matter) over a long stretch is that this time really is different, there's a new normal. Perhaps that should be a new norm (mean). I don't think anyone expects the US to ever again produce 1/4 of the world's output. Things do change. The difficulty is in recognizing when.

    Still I agree that patience is essential.

    https://infogr.am/Share-of-world-GDP-throughout-history
    (Interesting graphs - China peaked at 1/3 of the world's GDP around 1820, and has been on a trajectory back that way this century.)
  • edited July 2016
    I think that if the stock indexes reverted to their historical mean the would be significantly lower from today's prices.
  • "Housel subtitled his piece: “the long wait”. That’s appropriate. Patience can be severely tested. The quandary for investors is that nobody can forecast how long that wait is and when it will end. But be confident that it will end"
    +++++++++++++++

    How do you see this in the light of the Japan stock market experience?
    And the experience of Japanese citizens who invested in their stock market at the end of the 1980's?

  • In flat, overvalued, mean reverting markets, this is where tactical / quantitative processes become useful. Even the use of a strategy as simple as an empirically derived, price / moving average cross heuristic has produced risk managed alpha in the U.S. and Japan markets over a 30+ year sample. As the global environment appears to be mired in deflation, the inverse correlation of bonds to equities have continued in times of uncertainty.
    https://docs.google.com/presentation/d/1Sn6BKRCKRU5tensBDFTkJXI3v2wRQ4M1bt8VoIM2Zmc/edit?usp=sharing
    https://docs.google.com/presentation/d/1mdon_cto48rvs2_lKWyMWrfqSIh8K0phfe7tThle8qQ/edit?usp=sharing
    https://docs.google.com/document/d/1XwZjcWy7KlSwA7xi0rax7nevIBCtW0Uu4UZFH-Hc1ns/edit?usp=sharing
  • MJG
    edited July 2016
    Hi Guys,

    Hallelujah!! It was a great celebration of our Nation’s birthday. The fireworks were launched early, were continuous, were extensive, and lasted well into the night.

    Given the costs of these fireworks, one interpretation is that the South Bay area of Los Angeles is highly prosperous and confident. A less forgiving explanation is that the South Bay is populated by very spendthrift, but proud, citizens. As anticipated, I did overeat, but enjoyed it all.

    Thank you for taking time to participate in this discussion. I did not anticipate such deep and appropriately nuanced responses. It’s always a good policy to seek and consider a diverse set of interpretations on any matter. That mostly produces better decision-making.

    The submittals have ventured down a pathway not expected. That’s good. I agree with much of what has been said.

    Inflation matters. That’s why I like to assess investment returns after adjusting for it. Averages don’t say it all; investment return volatility acts to corrupt end wealth which is pathway dependent based on that volatility and drawdown policy during retirement. That’s why I like Monte Carlo analyses when making retirement decisions. Equity returns are likely to be muted in the near future relative to historical averages, so I expect the averages to drop a little due to a near-term quiet productivity growth rate period.

    I have no opinions about the Japan marketplace. It is a challenge to just keep pace with developments in the USA. Emotions are a huge factor in moving the marketplace, and the Japanese and American populations behave differently in that dimension.

    In considering our divergent characteristics, I probably oversimplify to reach a faulty decision, but I am reminded of a famous soldier’s axiom. I am now quoting General George Patton. He said: “A good plan violently executed NOW is better than a perfect plan executed NEXT WEEK”.

    I am not sure anyone can generate or define a perfect plan. Timing and decisiveness matters greatly when investing. Please understand I take no issue with Japanese folks. I have played tennis with one such terrific competitor twice a week for over 20 years.

    Timing and decisiveness are delicate subjects in the investment world. It means different things to different folks at different times during a dynamic environment. When does good enough outweigh perfect? My answer is always.

    I suppose that’s what I was thinking about when I closed my initial post with a few comments that distinguish between a Satisficer and a Maximizer. I am definitely a Satisficer. Based on some posts, MFO has a cohort of Maximizers. That mix is good since it makes for a vibrant marketplace.

    Well, I’ve likely written myself into yet another hole. That’s okay because it’s only my opinion. Thank you all once again for contributing during holiday obligations.

    Best Wishes.
  • @MJG As usual, I find your wisdom very helpful. I've been a maximizer with my investment philosophy, and it hasn't served me well. I've plunged into active funds that seemed to have everything going for them. Some have outperformed; others have underperformed; and on balance, especially since most of my investments are in a taxable account, I would have been better off in index funds. And the whole process has been a gigantic time suck.

    " Instead, being satisfied with near Index returns is easily accomplished with little effort and even little time commitment." This is what I'm aiming for now although, like an addict, I find myself thinking, "just one more active fund, this one really ought to be a winner, but it's the last, I promise."

    And despite relative underperformance I am sitting on sizable capital gains, so it may be more a question of new money going into index funds.

    My personal experience is of course not meant as criticism of the many participants on this board who've managed to consistently choose outperforming funds. My hat is off to you guys, but I don't have what you do.
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