Mean Reversion in Investing

By Penny Counts

“What goes up must come down.” This old adage doesn’t just apply only to physics—it also plays an interesting role in financial markets. This is mean reversion that blends statistical insight with Investment and trading strategy, challenging our instincts and reshaping how we view performance—especially when it comes to mutual funds, stocks, and other financial assets.

Fundamentally, mean reversion is the idea that prices and returns eventually move back toward their historical average or "mean." Whether we’re observing stock prices, earnings, volatility, or even ratios like P/E (Price-to-Earnings), the concept suggests that large deviations are often temporary, and that normalcy has a gravitational pull. Stock prices in the short term are driven by sentiments and herd behaviour, which may cause an unreasonable increase or decrease in the stock prices beyond the intrinsic value of the stock and sentiments are bound to change and when that happens, stock prices tend to move towards the mean. Understanding the concept of mean reversion can help an investor in taking relevant investing decision and protect her portfolio from undue risk. 

The Psychology Behind Chasing Winners

We all must have made a mistake at some point of our investment journey to opt for a red hot share or a fund which has delivered extraordinary return in recent past, owing to the behavioral concept called, recency bias.

Now, recall choosing a mutual fund simply because it had the best returns over the past two years. That is what many ordinary investors do. What happened to those extraordinary returns?

A study by Advisor Perspectives examined the return of various Mutual Fund schemes viz Index return, 1,087 U.S. active equity mutual funds that survived from late 2010 through mid‑2020. Their analysis showed that only 7% of funds rated five stars maintained that rating over the subsequent five years, and just 6% retained five stars through the full ten-year period.

Similarly, in the Indian context, the 2023 SPIVA India Scorecard revealed that 52% of large‑cap equity funds underperformed the S&P BSE 100 benchmark over the full year. Over longer horizons, underperformance worsened: approximately 87.5% lagged the benchmark over three years and 85.7% over five years . The mid and small‑cap equity funds did slightly better—around 74% underperformed in 2023, and 75% over the past decade —while ELSS funds stood out, with only 30% underperforming the S&P BSE 200. Overall, more than 60–70% of active Indian equity funds failed to beat benchmarks over 3 to 5‑year periods, underscoring the difficulty of sustained outperformance.

What happened? - Reversion to the mean

Bull Market gives an individual investor a false impression that they have acquired the skill to identify the multibaggers or have mastered the winning strategy. Post COVID bull phase reinforced the idea that the equity market is a money making machine with no end. However, Mean Reversion came to play as a rude shock when valuation streched too far. Combined with the "Trump tantrum", stocks corrected around 20-30% from their peak.

Therefore, investors often mistake luck for skill, and in doing so, they fall into the trap of performance chasing. As Jason Zweig wisely put it, “Buying funds based purely on their past performance is one of the stupidest things an investor can do.”

Ace investor, Shankar Sharma calls it 'Lake of Return' theory. He enumerates that when the “lake” is empty (i.e., past returns were low or flat), there's a high probability of strong future returns. Conversely, when the lake is overflowing (i.e., returns have been exceptionally high), impending weak or negative returns often follow.

What the Data Tells Us

Two landmark studies demonstrated mean reversion in mutual funds across 5-year blocks:

- 2006–2011 vs. 2011–2016: Only 13% of top-performing funds stayed on top. A stunning 27% fell to the bottom quintile, and 10% didn't even survive.

- 2001–2006 vs. 2006–2011: Just 15% of winners remained winners. A larger 18% of the bottom performers became top quintile in the next phase.

This randomness highlights a crucial truth: past performance is a poor predictor of future returns. We are, as Nassim Nicholas Taleb says, “fooled by randomness.”

Mean Reversion as a Trading Strategy

Traders apply mean reversion in various ways, especially in sideways or bullish markets where relationships between assets are more stable.

Key Components of the Strategy:

1. Identify Assets: Look for assets with historically mean-reverting characteristics.

2. Calculate the Historical Mean: Use long-term averages of price, P/E, or earnings yield.

3. Spot Deviations: Use tools like Bollinger Bands, RSI, or standard deviation to identify overbought or oversold conditions.

4. Trade the Reversion: Buy undervalued assets expecting them to rise; short overvalued assets expecting them to fall.

5. Manage Risk: Always use stop-losses, position sizing, and diversified exposure.

Pairs trading is a well-known application—trading two correlated stocks when their relationship temporarily diverges.

“Mean reversion is truly market neutral. In its most common application, pairs trading, it looks for cointegrated assets and identifies tradable pairs.”

– Marco Santanche

When Mean Reversion Fails

Though powerful, the strategy isn’t bulletproof. During bear markets or periods of structural disruption, historical relationships break down. The strategy also struggles with time-series reversal, which can happen so quickly that even skilled traders can’t respond in time.

“Time series reversal is difficult as it is to time the market in general. It can happen fast and revert even faster.”

– Marco Santanche

Moreover, fundamental shifts—like changes in regulation, interest rates, or disruptive innovation—can permanently shift the mean, rendering past averages obsolete. 

Mean Reversion in Earnings, Not Just Prices

The phenomenon extends beyond stock prices. Studies show reported earnings also revert to the mean over time. High-growth companies often face pressure to sustain earnings, but due to competition, market saturation, or cyclical forces, their earnings also tend to settle back toward industry norms.

Cognitive Bias: Why We Ignore Reversion

Daniel Kahneman, Nobel laureate and author of Thinking, Fast and Slow, noted that humans prefer causal explanations over statistical truths. When a fund performs well, we look for the "why"—great management, unique strategy—but ignore the statistical probability that it's just random fluctuation.

“Regression to the mean has an explanation, but does not have a cause.”

– Daniel Kahneman

Final Thoughts: Don’t Chase Stars, Buy the Market

Just as meteors light up the sky briefly before burning out, most star fund managers lose their luster. Over decades, index funds have outperformed the vast majority of actively managed funds, especially after adjusting for taxes and fees.

“To be 95% certain a manager is skillful, it can take up to 800 years.” – Ted Aronson

So what should investors do?

- Focus on low-cost index investing.

- Avoid performance chasing.

- Understand the power of averages.

- Build a strategy that respects reversion to the mean.

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Ref:

"Common Sense on Mutual Funds" by John C. Bogle

"Thinking, Fast and Slow" by Daniel Kahneman

"Fooled by Randomness" by Nassim Nicholas Taleb

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