Common Sense on Mutual Funds: Fully Updated 10th Anniversary Edition

Chapter 10. On Reversion to the Mean: Sir Isaac Newton's Revenge on Wall Street

At first blush, the principle of reversion to the mean might seem a slightly dry and uninspiring subject. I assure you, it is anything but that. This principle from the theoretical world of academe has proven to be wholly pragmatic in the very real world of the financial markets. It is evident in the relative returns of equity mutual funds, in the relative returns of a whole range of stock market sectors, and, over the long term, in the absolute returns earned by common stocks as a group. Reversion to the mean (RTM) represents the operation of a kind of law of gravity in the stock market, through which returns mysteriously seem to be drawn to norms of one kind or another over time. This application of the universal law of gravity might even be characterized as Sir Isaac Newton's revenge on Wall Street.

As investors, many of us have chosen mutual funds as all or part of our investment programs. Whether funds are a part of your portfolio or not, you have probably carefully considered your own financial circumstances and risk tolerances, and decided on your optimal allocation of assets between fixed-income investments and stocks. And if you share in the powerful and rarely challenged ethos of our era—that common stocks are virtually certain to provide the highest returns of any major asset class over the long term—a substantial portion of your program may well be invested in equity funds.

Assuming that is ...