Live Long and Prosper

| October 28, 2022

Education and intellect do not protect us from our psychological blind spots. There is no Mr. Spock who is a flesh-and-blood-computer devoid of emotions. Even if there were, it wouldn’t help us. Those who regularly read our newsletter may recall how often I have stressed that when stock prices are high, our expected future returns should be low. Inversely, when prices are low, we should anticipate that future returns will be higher. In finance, we call this mean reversion. Of course, I am oversimplifying due to the limits of space.

Few people know more about mean reversion than finance professors. Yet, even they are prone to overestimate future returns during bull markets, when prices are elevated, and tend to underestimate future returns during bear markets when prices are depressed. John Nofsinger, whom I quoted in last week’s blog (read here), recounts the responses to two surveys of 226 finance professors. First, understand that the idea behind mean reversion is that the stock market overshoots the mean on the upside and on the downside, ultimately returning to the mean between the two. Again, I am oversimplifying. When asked, “the professors tended to lean toward the belief that the stock market mean reverts. The first survey took place in 1999, at the end of the internet bull market. In 2001, under radically changed circumstances, the professors were surveyed again. This time they made estimates for future returns that were “considerably lower than estimates provided only three years earlier.” * In other words, even though in both surveys the professors stated their belief that prices would eventually return to the mean, they overestimated future returns during bull markets and underestimated future returns during bear markets. This is exactly the opposite of what we would expect and what I have written in the newsletter for several years now.

Since none of us are pointy-eared Vulcan scientists, we need to utilize strategies that overcome our inherent limitations. One of these is rebalancing. Once we determine an allocation among stocks, bonds, and cash, both foreign and domestic, we periodically and systematically rebalance back to our stated allocation. This forces us to sell some securities that are overpriced and buy other securities that are underpriced. We can also increase our allocations to areas that are below the mean, or add commodities and real estate if called for, thus further setting ourselves up for improved long-term expectations.

Live long and prosper.

*** Nofsinger, J. R. The Psychology of Investing, 6th ed.. (Routledge, 2018).