Reversion or regression to the mean is a simple, but yet often overlooked principle. In a nutshell, it explains in part, why prices move up, down, then up and then down again. Mean reversion is a concept familiar with technical analysts, through the use of moving averages or standard deviation for example, but the theory is often missed by fundamentalists.

Here is a definition of mean reversion, courtesy of Investopedia:
‘Mean reversion is financial theory suggesting that asset prices and returns eventually return back to the long-run mean or average of the entire dataset. This mean or average can be the historical average of the price or return or another relevant average such as the growth in the economy or the average return of an industry.’

When reading the financial news, you may see how economists and various forecasters talk about how a range of economic indicators, such as a gross domestic product, wage inflation, consumer price index or even house prices, have an influence on future expectations in their analysis. But very few talk about the simple fact that prices of securities have diverged a great distance away from the average price or mean.

In a test conducted by John (Jack) Bogle in his book, ‘The Little Book of Common-Sense Investing’, he monitors the performance of the top 20 funds between 1982-1992 and 1995-2005. In both periods, the top 20 funds, in their respective periods, were in the top quartiles based on their performance. In the subsequent years after their outperformance, these funds dropped to the bottom quartile, thus becoming the worst performers. The disclaimer most brokers will have on their website, 'past performance is not indicative of future performance', rings true with this little test conducted by Jack Bogle.

Essentially, a company’s balance sheet may be as solid as a solid thing, but if investors think otherwise, the share price is not going to perform as you would expect, and you may suffer financially and emotionally. The financial markets are not short of adages and famous quotes, but something that is comparable to the stock market, is physics and more predominantly the adage, ‘what goes up, must come down’. In other words, share prices typically cannot continue in an upwards trajectory forever; though it may seem that way!

This makes for a daunting realisation when you…

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