Regression to the Mean

A recent Wall Street Journal titled “Rebound of the Losers” from July 6, 2009 described how some specific actively managed mutual funds with large losses recently booked better performance. From the article

Ninety-four diversified U.S.- stock funds that finished 2008 in the bottom 10% of their peers are now performing in the upper 25% of their categories

The article then described their reasons why these specific managers were able to “rebound”. They included:

– purchased shares of better-performing foreign companies (the markets in China and Russia, for example, fell further and later rebounded better as a % than US markets)
– commodity markets improved, so stocks with a commodity footprint like energy benefited
– some managers described their own “guts”

“It’s funny how quickly things can change,” Mr. Soviero says, “but I’m glad I had the level of conviction and stuck with a concentrated strategy.”

– others used terms like “discipline” and said they were looking for companies with a “sustainable advantage”

But the journalist on the article missed the simplest, and most obvious answer –

REGRESSION TO THE MEAN

What this means, in practical terms, is that stocks or sectors that have the largest rise now are likely to fall later, and vice versa. One financial magazine I read had “Chicos”, the clothing store, as the “worst” performer over the last year, and the “best” performer over the prior decade, in back to back pages.

Something to watch for, especially when people describe their recovery in personal terms, rather than ascribing it to typical market “bounce”.

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