Regression to the mean investing in mutual funds
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Introduction Regression to the mean is generally not used by investors to made investment decisions. This is because people in general and investors tend to use have the recency bias as a far greater influencer on their decision making.
Recency Bias Before getting into regression to the mean it is important to review recency bias. This is explained in the following quotation. When it comes to investing, recency bias often manifests in terms of direction or momentum. It convinces us that a rising market or individual stock will continue to appreciate, or that a declining market or stock is likely to keep falling.
This bias often leads us to make emotionally charged choices—decisions that could erode our earning potential by tempting us to hold a stock for too long or pull out too soon. Or, in the case of individual stocks, investors place too much weight on what recently happened when making investing decisions. Regression to the mean is the tendency of trends to backtrack. Unfortunately, not any expert can predict when that will happen in a reliable, reproducible manner.
But as the zero return environment lengthens, the odds of a recovery to the historical average annual returns increases. Incrementally increasing your equity positions during this difficult period will surely not maximize your total end wealth since only precisely picking the market bottoms can do that. In that sense, investors should be satisficers and not maximizers.
There just are too many fund choices and too much uncertainty to ever fully realize maximizer perfection. Any attempt to do so will ultimately end in unhappiness at our failures to accomplish that lofty target. Instead, being satisfied with near Index returns is easily accomplished with little effort and even little time commitment.
I practice that discipline. The percentage of professional money managers who successfully maximize returns, using an Index as a measure of their success, is grimly low. The evidence is in their dismal performance records. Please enjoy the fireworks and the feasting.
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