Against the Gods: The Remarkable Story of Risk (35 page)

Their findings were unequivocal: "Over the last half-century, loser
portfolios ... outperform the market by, on average, 19.6% thirty-six
months after portfolio formation. Winner portfolios, on the other hand,
earn [produce returns] about 5.0% less than the market."3

Although DeBondt and Thaler's test methods have been subjected
to some criticism, their findings have been confirmed by other analysts
using different methods. When investors overreact to new information
and ignore long-term trends, regression to the mean turns the average
winner into a loser and the average loser into a winner. This reversal
tends to develop with some delay, which is what creates the profitable
opportunity: we could really say that first the market overreacts to
short-term news and then underreacts while awaiting new short-term
news of a different character.4

The reason is simple enough. Stock prices in general follow changes
in company fortunes. Investors who focus excessively on the short run
are ignoring a mountain of evidence demonstrating that most surges in
earnings are unsustainable. On the other hand, companies that encounter
problems do not let matters slide indefinitely. Managers will set to work
making the hard decisions to put their company back on track-or will
find themselves out of a job, replaced by others more zealous.

Regression to the mean decrees that it could not be otherwise. If
the winners kept on winning and the losers kept on losing, our economy would consist of a shrinking handful of giant monopolies and
virtually no small companies at all. The once-admired monopolies in
Japan and Korea are now going through the opposite process, as regression to the mean in the form of irresistible waves of imports is gradually weakening their economic power.

The track records of professional investment managers are also subject to regression to the mean. There is a strong probability that the hot
manager of today will be the cold manager of tomorrow, or at least the
day after tomorrow, and vice versa. This does not mean that successful
managers will inevitably lose their touch or that managers with poor
records will ultimately see the light-though that does tend to happen.
Often investment managers lose ground simply because no one style of
management stays in fashion forever.

Earlier, in the discussion of the Petersburg Paradox, we noted the
difficulty investors had in valuing stocks that seemed to have infinite
payoffs (page 107). It was inevitable that the investors' unlimited optimism would ultimately lift the price of those growth stocks to unrealistic levels. When regression to the mean sent the stocks crashing, even
the best manager of growth-stock portfolios could not help but look
foolish. A similar fad took over small stock investing in the late 1970s,
when academic research demonstrated that small stocks had been the
most successful long-run investment despite their greater risk. By 1983,
regression to the mean had once more set in, and small stocks underperformed for years afterward. This time, even the best manager of
small-stock investment could not help but look foolish.

In 1994, Morningstar, the leading publication on the performance of
mutual funds, published the accompanying table, which shows how
various types of funds had fared over the five years ending March 1989
and the five years ending March 1994:5

This is a spectacular demonstration of regression to the mean at
work. The average performance in both periods was almost identical,
but the swings in results from the first period to the second were enormous. The three groups that did better than average in the first period
did worse than average in the second; the three groups that did worse
than average in the first period did better than average in the second.

This impressive evidence of regression to the mean might provide
some valuable advice to investors who are constantly switching managers.
It suggests that the wisest strategy is to dismiss the manager with the best recent track record and to transfer one's assets to the manager who has
been doing the worst; this strategy is no different from selling stocks that
have risen furthest and buying stocks that have fallen furthest. If that
contrarian strategy is hard to follow, there is another way to accomplish
the same thing. Go ahead and follow your natural instincts. Fire the lagging manager and add to the holdings of the winning manager, but wait
two years before doing it.

What about the stock market as a whole? Are the popular averages,
like the Dow Jones Industrials and the Standard & Poor's Composite of
500 stocks, predictable?

The charts in Chapter 8 (page 147) show that market performance
over periods of a year or more does not look much like a normal distribution, but that performance by the month and by the quarter does,
though not precisely. Quetelet would interpret that evidence as proof
that stock-price movements in the short run are independent-that
today's changes tell us nothing about what tomorrow's prices will be.
The stock market is unpredictable. The notion of the random walk was
evoked to explain why this should be so.

But what about the longer view? After all, most investors, even
impatient ones, stay in the market for more than a month, a quarter, or
a year. Even though the contents of their portfolios change over time,
serious investors tend to keep their money in the stock market for
many years, even decades. Does the long run in the stock market really
differ from the short run?

If the random-walk view is correct, today's stock prices embody all
relevant information. The only thing that would make them change is
the availability of new information. Since we have no way of knowing
what that new information might be, there is no mean for stock prices
to regress to. In other words, there is no such thing as a temporary stock
price-that is, a price that sits in limbo before moving to some other
point. That is also why changes are unpredictable.

But there are two other possibilities. If the DeBondt-Thaler hypothesis of overreaction to recent news applies to the market as a whole and
not just to individual stocks, regression to the mean in the performance
of the major market averages should become visible as longer-term real ities make themselves felt. If, on the other hand, investors are more fearful in some economic environments than in others-say, 1932 or 1974 in contrast to 1968 or 1986-stock prices would fall so long as investors are afraid and would rise again as circumstances change and justify a more hopeful view of the future.

Both possibilities argue for ignoring short-term volatility and holding on for the long pull. No matter how the market moves along the way, returns to investors should average out around some kind of longterm normal. If that is the case, the stock market may be a risky place for a matter of months or even for a couple of years, but the risk of losing anything substantial over a period of five years or longer should be small.

Impressive support for this viewpoint appeared in a monograph published in 1995 by the Association for Investment Management & Research-the organization to which most investment professionals belong-and written by two Baylor University professors, William Reichenstein and Dovalee Dorsett.6 On the basis of extensive research, they conclude that bad periods in the market are predictably followed by good periods, and vice versa. This finding is a direct contradiction of the random-walk view, which denies that changes in stock prices are predictable. Stock prices, like the peapods, have shown no tendency to head off indefinitely in one direction or the other.

Mathematics tells us that the variance-a measure of how observations tend to distribute themselves around their average level-of a series of random numbers should increase precisely as the length of the series grows. Observations over three-year periods should show triple the variance of observations over one year, and observations over a decade should show ten times the variance of annual observations. If, on the other hand, the numbers are not random, because regression to the mean is at work; the mathematics works out so that the ratio of the change variance to the time period will be less than one.*

Reichenstein and Dorsett studied the S&P 500 from 1926 to 1993
and found that the variance of three-year returns was only 2.7 times the
variance of annual returns; the variance of eight-year returns was only
5.6 times the variance of annual returns. When they assembled realistic
portfolios containing a mixture of stocks and bonds, the ratios of variance to time period were even smaller than for portfolios consisting
only of stocks.

Clearly, long-run volatility in the stock market is less than it would
be if the extremes had any chance of taking over. In the end, and after their
flings, investors listen to Galton rather than dancing along behind the Pied Piper.

This finding has profound implications for long-term investors,
because it means that uncertainty about rates of return over the long
run is much smaller than in the short run. Reichenstein and Dorsett
provide a wealth of historical data and projections of future possibilities,
but the following passage suggests their principal findings (based on results after adjustment for inflation):7

For a one-year holding period, there is a five percent chance that
investors in the stock market will lose at least 25% of their money,
and a five percent chance that they will make more than 40%. Over
thirty years, on the other hand, there is only a five percent chance
that a 100% stock portfolio will grow by less than 20% and a five percent chance that owners of this portfolio could end up over fifty
times richer than where they started.

Over time, the difference between the returns on risky securities
and conservative investments widens dramatically. Over twenty years,
there is only a five percent chance that a portfolio consisting only of
long-term corporate bonds would much more than quadruple while
there is a fifty percent chance that a 100% equity portfolio would
grow at least eightfold.

Yet, this painstaking research gives us no easy prescription for getting rich. We all find it difficult to hang in through thin as well as thick.
And Reichenstein and Dorsett tell us only what happened between 1926 and
1993. Tempting as long-term investing appears in light of their calculations, their analysis is 100% hindsight. Worse, even small differences
in annual returns over many years produce big differences in the
investor's wealth at the end of the long-run.

The overreaction to new information that DeBondt and Thaler
reported in the behavior of stock prices was the result of the human
tendency to overweight recent evidence and to lose sight of the long
run. After all, we know a lot more about what is happening right now
than we can ever know about what will happen at some uncertain date
in the future.

Nevertheless, overemphasizing the present can distort reality and
lead to unwise decisions and faulty assessments. For example, some
observers have deplored what they allege to be a slowdown in productivity growth in the United States over the past quarter-century.
Actually, the record over that period is far better than they would lead
us to believe. Awareness of regression to the mean would correct the
faulty view of the pessimists.