Think Like the Great Investors: Make Better Decisions and Raise Your Investing to a New Level

Chapter 15

What goes up . . . (small numbers, reversion to the mean)

Most readers will be aware of the intuitive saying that encapsulates the idea of gravity: what goes up must come down again. This idea can be analogous to the stock market, because long experience has taught us that stocks that soar in price tend to become overvalued and, sooner or later, reality will bring their price back to earth, so to speak.

The cognitive biases of representativeness and ignoring the base rate were discussed in earlier chapters. One corollary to these cognitive biases is a trap that affects even those who accept the proposition that prices behave as though influenced by a kind of financial gravity. These investors fall into a logic error of basing their investing decisions on the reverse idea that stocks that fall in price must inevitably rise again.

On one level they have base rates working for them. This is the demonstrated tendency of prices to revert to the mean. In simple terms this means that prices get out of line, above or below realistic value, from time to time. They may become unrealistically high or unrealistically low. This is simply an expression of the dynamics of crowd behaviour and of the way we are all affected by fear and greed. Greed drives prices to overshoot value on the high side when people buy at silly prices as they are carried away by the euphoria of the crowd. ...