Profiting from Stats Class: Reversion to the Mean

This is a guest post from Mike at The Oblivious Investor.

Admittedly, the field of statistics isn’t terribly thrilling to most people. But if you really want to understand what’s going on with your investments, it’s necessary to develop at least a ground-level understanding of a few concepts from the field of stats.

For instance, standard deviation is rather important if you want to understand the nature of an investment’s volatility.

Similarly, understanding the concept of reversion to the mean (sometimes called “regression to the mean”) is likely to put dollars in your pocket.

What is reversion to the mean?

Let’s use a hypothetical example: 1,000 students are given a history test. The top 10 students earn an average score of 95%. The next day, all 1,000 students are given a test on similar subject matter, but with different questions. What do we expect to see?

The concept of reversion to the mean tells us that it’s very likely that the top 10 students from the first test will have a lower average score on the second test. Why? Because–while some of the students were surely at the top due to intelligence, preparation, etc.–some of the top 10 probably just got lucky. And it’s highly unlikely that the same exact group of students will happen to get lucky again the next day.

As a result, the top 10 from the first test will likely have an average score on the second test that is closer to the average score earned by the entire group of 1,000 students. That is, they’ll revert toward the mean.

The same thing happens if we look at the bottom 10 students from the first day. They’ll probably have a higher average score on day 2 than on day 1. In other words, reversion toward the mean occurs with both bottom performers and top performers.

Why should investors be concerned with this?

Simple: Because the same thing happens with fund performance.

Practically every fund, if given enough time, reverts back to the mean. (That is, back to the performance of the market.) Sometimes the reversion simply means having a few good years after a few bad ones–or vice versa. Other times, the reversion can be rather spectacular.

It’s extremely important to note here, however, that this reversion toward the mean for mutual funds appears to occur with before-expense results. Expenses, in contrast, tend to stay rather constant for most funds. Funds with high expenses last year will probably have high expenses this year.

So how can we profit from this phenomenon?

First, we can refuse to bet on a fund simply because of recent above-average performance.

Second, whether choosing funds for our 401k, IRA, or taxable account, we should always seek the lowest expenses possible.

About the Author: Mike writes at The Oblivious Investor, where he regularly reminds readers to ignore temporary things like recent performance, and focus instead on things that truly matter. If you like this post, subscribe to his blog to read more.