How you can use mean reversion to drive investment returns

One of the challenges that many investors face is deciding what to invest in, how much and when. There are three methodologies that you can employ to help make this decision, but only two are supported by evidence.

What is mean reversion?

Mean reversion is a financial theory that suggests a period of above average returns is often followed by a period of below average returns, such that the average return over both periods is close to an asset class’ long term mean (or average) return.

Many academics have studied mean reversion and concluded it is an observable and repeatable trend in financial markets.

Mean reversion makes sense. It is unlikely that an asset class can generated above average returns for an unlimited period of time. For example, the S&P500 index (US market) has returned over 15% p.a. over the past 12 years. Its long term mean return is close to 10% p.a. Therefore, the probability of it delivering that return again over the next 10 years (thereby generating a return over 15% p.a. over a 20-year period) is very low. In fact, modelling suggests the probability of that occurring is less than 1%.

Examples of how perspective & mean reversion helps with investment decisions

I recall that towards the end of 2011, the AUD/USD exchange rate was close to parity (i.e. $AUD1 = $USD1). This meant that it was a good time to invest in the US market (because Australian dollars was more valuable). However, in the 10 years ended December 2011, the S&P500 index had delivered a return of close to zero. As such, an investor would have been excused for discounting such an investment opportunity, because why would you invest in a market that had delivered a zero return over the past 10 years!? Sure, the exchange rate was favourable, but that alone doesn’t validate the investment.

Since the end of 2011, the index has delivered a return over circa 14% p.a. and the Australian currency has fallen 30% (relative to the US), resulting in a total return of circa 18% p.a. Mean reversion together with a low-cost index fund have done most of the heavy lifting.

Perhaps the most obvious market at the moment that is likely to benefit from mean reversion is the investment-grade apartment market. As I wrote in this blog last year, investment-grade apartments (in Melbourne in particular) have delivered very little capital growth over the past 10 years. If the trend of mean reversion repeats itself, and it will, it is very likely that we are approaching an 8-10 year period double-digit capital growth. No one knows when the growth period will begin. But 4 to 5 decades of evidence tells us it will begin eventually.

Of course, it’s difficult to invest when recent returns have been poor

We are all wiser with hindsight. Looking back at my 2011 US share market investment example above, it seems like a no brainer today. However, at the time, it wasn’t. Its counter-intuitive to invest in markets that haven’t performed in recent years. It often feels less risky to invest opportunities that are currently most popular i.e. follow the herd. But it’s not. Astute investing requires discipline and courage.

It’s much easier to pick medium-term (or longer) trends

I wrote last week that it’s very tempting to focus on investing opportunities that promise quick returns. However, as the illustration below highlights, it is a highly speculative approach. A far superior approach is to invest primarily using a very long-term lens. This invites you to focus almost entirely on (1) only adopting evidenced-based methodologies and (2) focusing on investing in the highest quality assets. It helps you drown out unhelpful noise.

See here

However, if your risk appetite permits, you might like to use a combination of medium and longer term approaches. For example, if a client’s investment strategy includes investing in both property and shares, we might adopt the following approach:

1. When investing in property, we’ll use a pure long-term approach. Because property is a lump asset i.e. you must invest a large amount, it’s important to take the lowest-risk approach; and

2. When progressively invest in shares, we might first invest in the geographical markets and/or sub-asset classes that exhibit the best opportunities for delivering above-average returns in the medium term. That is, relying on the trend of mean reversion.

Have cash but don’t know when to invest it?

Low interest rates can create a sense of urgency for some investors. That’s because leaving your money in cash rewards you with very little interest (term deposit rates are less than 1% p.a. and mortgage offsets save you maybe 3% p.a.). Consequently, some investors feel compelled to invest their money elsewhere.

Alternatively, some investors are concerned that property and share markets are trading close to all-time highs, and don’t feel confident investing in case the market crashes.

However, whether to invest or not is rarely an all-or-nothing decision. That is, it’s unlikely the right response is to invest nothing at all and leave your money in cash. But, by the same token, it’s probably foolish to invest all your money tomorrow. Instead, often the most prudent response lies somewhere in between.

If all else fails, go long term

As I have written ad nauseam, the lowest risk approach is to focus on the long term. Invest in a way that will maximise your wealth 20 years from now, close your eyes and have faith. As long as you’ve made a fundamentally sound investment, this is sure to be the lowest stress approach to investing.