Everything in a world moves toward an extreme direction from average and come back to average. This is known as a regression to mean. Sometimes we get more happy or sad and as time passes, we start coming back to our normal feelings. We tend to be nice to other people when they please us and nasty when they do not, we are statistically punished for being nice and rewarded for being nasty.
Poor performance was typically followed by improvement and good performance by deterioration, without any help from either praise or punishment. Our performance has an average point, sometimes we perform very better than average and sometimes perform below average and sometimes reach back to mean performance. So that when performance is above or below average, then it has a higher probability to meet the average which is known as a regression to the mean.
Investment – The price of the companies sometimes go either extreme to fundamental points but as time passes stock prices start moving towards fundamental performance and at some point fundamental performance and stock prices marched. The stock price cannot be sustained at either extreme. We have seen various cyclical events, business cycle and many more are responsible for the regression to the mean. We have experienced that market always walk away from averages for a period but it comes near to mean by its self-correcting nature. So that when anything moves at the extreme side of the mean then we must have to be ready for self-correction of it. Value investing mainly focus on reversion to mean theory. It believes that if the stock price is well below its fundamental value then now or later it will catch up with its fundamental value.
We have seen that the best performance in equities has come after the worst performance and vice-versa. So that we should not focus on a smaller period of outcome to make any conclusion. Rather should focus on a decently long period to understand mean reversion. But when fundamental performance is improving then we should compare market price with improving fundamental performance rather should wait to fall in price as it has risen in past. Also, we need to study thoroughly about fundamental of any business, its prospects, challenges faced by the business. Rather believing that if the business has performed well in past then it will repeat it in future. It may or may not repeat the same performance but that we have to conclude from a detail study of business.
This entire series will be review with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.