Buying and selling stocks would be much easier if only there were an investment indicator that was dependable. One indicator in particular has lured many investors into its seemingly sound logic. Mean reversion. This is a fancy term for a historical observation that good market climates tend to follow bad … and vice-versa. Or, put simply, what goes up must come down.
Looking back on market history, we see evidence of mean reversion. The “tech wreck” of 2000 to 2002: skyrocketing stock values through 1999, followed by a precipitous fall in early 2000. The financial crisis of 2008 is another example. We see mean reversion in our everyday life too. In the physical world as gravity (what goes up must come down) and even our health. When we get sick, we tend to “mean revert” to our healthy state.
If mean reversion is real and reliable, can we employ it to time when to buy and sell stocks? It’s incredibly tempting, right? Imagine if you went to cash just before the tech wreck at the turn of the century, and then bought stocks at the low. You would have made a killing. And the bragging rights would be off the charts!
Unfortunately, it’s a unicorn.
As Wall Street Journal columnist Jason Zweig has defined in his Devil’s Financial Dictionary, there’s only one problem with depending on what tomorrow has in store for investors, based on today’s “certitudes.” The certainty doesn’t exist:
CERTAINTY, n. A state of clarity and predictability in economic and geopolitical affairs that all investors say is indispensable — even though it doesn’t exist, never has, and never will.
– Jason Zweig
Devil’s Financial Dictionary
By and large, Zweig has got it right. There are ample, evidence-based strikes against using current indicators to identify when to buy and sell stocks as a strategy to build wealth. As Dimensional Fund Advisor’s Jim Davis explains in this video: “While we cannot rule out the existence of mean reversion, after looking at 780 tests, we just don’t see evidence that mean reversion is strong enough to permit profitable trading strategies.”
If you ask us, this gives us 780 more reasons for investors to build personalized, globally diversified portfolios that reflect their own goals and risk tolerances, and to stick with their portfolios through the market’s many moods.