Mean reversion - A powerful force

The pandemic has had an extreme impact on economies and markets, yet there is an even stronger force that few are comfortable acknowledging.

It has helped mitigate the effect of COVID-19 and it needs no casual explanation (despite our human tendency to look for explanatory stories), which makes it a deeply uncomfortable concept.

Yet mean reversion is a pervasive force in the world any time luck is involved in an outcome.

Correlations and mean reversion very often go hand-in-hand, whereby whenever the correlation between two measures is less than 1 (or "perfectly correlated") and more than zero (or "zero correlation") there is a strong change that reversion to the mean will likely occur.

It explains the way extreme prices, profits, valuations, economic growth - and multiple other measures of interest to investors - tend to return to their long-term mean. It can even be an explanation for why an Olympic High-Jumper who has a bad first-round attempt is more likely to have a better second attempt! (And note I say Olympic High-Jumper - you and I are probably more likely to have three failed attempts and possibly a torn muscle).

Evidence abounds in the world of investing.

Sometimes mean reversion can take many years, even decades, but usually cycles are much shorter in nature and hence their importance. The Nobel Laureate Robert Shiller is known for his work in producing an extensive database of investment data that shoes long-term mean reversion at work.

For example, the graph below shows S&P 500 earnings on a logarithmic scale (as they compound over time) and as you can see, the extreme outliers clearly revert to the mean:

The price investors are willing to pay for equities also tends to revert to the mean, with the following graph showing the price investors were willing to pay for the local Australian share market based on aggregate prior sales over the last five years:

We've taken two fairly basic graphs (with one relating to corporate profitability and the other relating to pricing) to show that even across various investment-related measures, there is always a case in considering the powerful effects of mean reversion and what it may mean for asset allocation, or on a more granular level, stock-picking, over various investment cycles.

What are the lessons for investors?

We all want a reason to explain events, but many outcomes are the result of uncorrelated factors, and luck can play a significant role. Although, this doesn't mean investor skill is non-existent and causal events have no impact on outcomes.

Yet most (skilled) investors still assume they can control outcomes by using this skill far beyond its ability to influence outcomes. It's dangerous territory.

By accepting mean reversion, and incorporating the powerful force into investment processes, investment managers (as well as individual investors) will find it can be a key driver of not only forecasting returns, but also a key driver of risk management.

A recent example (and a trade we took on at Innova) was during the volatile markets of 2020 when the pandemic created a highly unpredictable environment. This, in turn, meant we could expect mean reversion to occur. Anyone reading this who enjoys the commodity markets may recall the scenario: By understanding the simple gold-to-silver ratio, and historical trends, there was a trade to be made in applying simple logic when it comes to mean reversion. 

Silver has historically traded at a gold-to-silver ratio of around 70 and typically trades anywhere between 50 and 100 throughout a regular investment cycle. When silver hit an all-time high of 125 based on the ratio in March of 2020, a simple silver purchase and subsequent waiting for mean reversion to occur was the catalyst for strong returns in a short period.

  Silver peaking at 125 in March of 2020 in comparison to gold via gold-to-silver ratio. Mean Reversion was bound to happen at some point, and as shown it happened quite quickly.

Source: (VIEW LINK) title="https://goldprice.org/gold-silver-ratio.html" href="https://goldprice.org/gold-silver-ratio.html" rel="noopener noreferrer" target="_blank" tabindex="-1" style="font-size: 0.8em;">(VIEW LINK)

While a short-term example (and admittedly one that bore fruit sooner than expected - it had reverted by August and profits were taken) it's still a relatively simple example of where understanding the powerful force that is mean reversion can have impacts on portfolios. Whether they are significant impacts or not will come down to acknowledging and using this force – alongside intelligent diversification – to generate long-term performance that helps investors reach financial goals.

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