Fluctuation in asset prices — in both directions — is a fact of life in the financial markets. We all know that it’s impossible to predict either the direction or the severity of short-term price volatility. But given enough time, the overall trend of prices — especially in the equity markets is upward. So, we encourage our clients to “stay the course” during periods of volatility, to tune out the “market noise” and to remain committed to the long-term strategies we have helped them develop.
This is built on our belief that, over time, the observed long-term trends will reassert themselves. The statistical principle underlying this belief is, of course, reversion to the mean — the tendency of extreme or unusual results to be followed by more typical or average results over time.
When we tell clients that the stock market has returned roughly 7%, adjusted for inflation, since 1871, we’re appealing to this principle. We also know that in any given year the return is unlikely to be exactly 7%; it could be significantly higher or significantly lower — even negative. But given enough time, the 7% trendline has tended to be reliable.
When we counsel clients in or approaching retirement, however, we must take a number of other factors into account. The central question many of our clients are asking about their retirement is, “Will I have enough money to live the way I want, once I stop working?”
Our planning strategies, our financial modeling and our guidance are all geared to help our clients answer this question in the affirmative. And to do that, we must consider matters such as sequence-of-return risk, the inherent uncertainty of unexpected expenses (notably, healthcare), longevity risk and other variables.
In nearly all of these considerations, we are applying the principle of reversion to the mean, in one sense or another.
For example, when calculating longevity risk, we likely rely on actuarial tables, which are statistical representations of the probable lifespan of individuals, based on long-term averages and current data. When we discuss healthcare expenses in retirement, we often use projections based on data collected from specific populations over time, many of which involve averages.
Sequence-of-return risk, as well, involves the likelihood that a retired client will be forced to liquidate assets when prices are unfavorable — that is, when they are trending below and away from the long-term average.
In all of these cases, our client’s actual results may be the same, better, or worse. All reversion to the mean can give us is a long-term trend that we can then use to create various scenarios for planning purposes.
For example, we tell clients that if markets provide much larger-than-historical returns on a sustained basis and become overvalued, expected returns going forward from this level will be lower than the 7% long term average until the market reverts to its fair value.
Even if the overall equity market as judged by the S&P 500 is overvalued, we remind them that there may be sub-asset classes of the equity market that are fairly or attractively priced (for example, international, small cap or value) and we may choose to invest there.
But if the equity market is broadly overvalued, we will consider other assets, such as bonds and cash; compare their risk adjusted returns; and make asset allocation changes accordingly.
A Double-Edged Sword
Especially when projecting portfolio returns, it’s important to remember that reversion to the mean works in both directions.
When markets are underperforming (which is when we tend to have the most conversations with clients), we would expect mean reversion to begin nudging prices higher at some point — which works in our clients’ favor. But the same principle applies when markets are outperforming. Reversion to the mean suggests that at some time in the future, prices are likely to begin falling back toward the average long-term trendline — less favorable to our clients.
The latter experience is exemplified by the so-called “Sports Illustrated Jinx.” The theory is that when an athlete appears on the cover of the magazine, he or she is then predestined to endure a period of worse performance. But rather than blaming it on a curse or a jinx, it’s more logical to assume that mean reversion is taking place. Why did the athlete appear on the cover? Likely, because they were in a period of above-average performance. But mean reversion suggests that the athlete’s future performance may be due for a period of results closer to average.
The double-edged nature of mean reversion can be especially important when discussing portfolio performance with retired clients.
The point we will want to make with them is that if we have helped them assemble a properly diversified portfolio that matches their tolerance for risk, if we are systematically keeping them “in plan” with rebalancing, and if we are managing their holdings for tax and fee efficiency, then we can trust that over the long term that reversion to the mean will work in their favor. This is for whichever side of the average they are on at the moment.
Focus on What You Can Control
We can never assert that understanding mean reversions gives us the ability to predict future price movements. But we can, with some assurance, use it to provide a context for price movements that encourages our clients to focus on the things they can control: diversification, proper asset allocation, rebalancing, and controlling their spending to the extent possible.
And we can use it discourage them from trying to control elements which are inherently beyond the control of any individual investor — or advisor — such as market pricing. We can also provide a logical construct that can help investors avoid making decisions prompted by emotional responses to market volatility.
Our clients depend on us to offer reliable counsel that is based on evidence, not intuition. Mean reversion can be an important tool to construct explanations that clients are able to readily understand and internalize. When we can give them sound reasons for confidence in their financial strategies for retirement, we deliver true value.
Scott Bondurant is the CEO and founder of Bondurant Investment Advisory. His prior roles include managing director and global head of long/short strategies at UBS Global Asset Management from 2005-2014. He was responsible for leading the development, implementation, and marketing of the UBS Global Asset Management’s $2.5 billion equity long/short platform. In addition, he has authored a series of white papers addressing topical issues related to long/short strategies. Scott was also a member of the equity management team, equity investment committee, and equity business committee at UBS. He is currently an adjunct professor at Northwestern University and has taught the course titled “The History of Investing” for 10 years. The Northwestern Business Review named this course as “one of the five coolest business-related classes.”
