Mean Reversion: Why Today’s Winners Are Tomorrow’s Losers
Mean Reversion: Why Today’s Winners Are Tomorrow’s Losers
COACHING POINTS
- The Law: In physics, what goes up must come down. In finance, asset prices eventually return to their long-term average valuation. This force is called Mean Reversion. It is the mathematical reason why “trees don’t grow to the sky.”
- The Trap: Investors suffer from “Recency Bias,” assuming that whatever performed well recently (e.g., US Tech Stocks) will continue to outperform forever. History shows the exact opposite: the best-performing asset class of one decade is often the worst of the next.
- The Strategy: You must be a contrarian. Systematic Rebalancing is the only way to harness mean reversion—forcing you to sell what is expensive (the recent winner) and buy what is cheap (the recent loser) before the cycle turns.
This time is different” are the four most expensive words in investing. Whether it was the Nifty Fifty in the 70s, Japan in the 80s, or the Dotcoms in the 90s, every parabolic asset eventually crashes back to its fundamental trend line. Mean Reversion is not a probability; it is an inevitability driven by capitalism’s tendency to compete away excess profits. Source: Jeremy Siegel (Stocks for the Long Run) / Callan Periodic Table
Scenario: Comparing US Stocks vs. Emerging Markets (EM) over two decades.
- The 2000s (2000-2009):
Winner: Emerging Markets (+160%).
Loser: US Stocks (-9%). (The “Lost Decade”).
Investor Sentiment in 2010: “US stocks are dead; put everything in China/Brazil.” - The 2010s (2010-2019):
Winner: US Stocks (+250%).
Loser: Emerging Markets (+40%).
Investor Sentiment in 2020: “Why own International? The US is the only game in town.” - The Lesson: The winner flipped perfectly. Investors who chased the 2000s winner missed the 2010s rally. Those chasing the 2010s winner are likely setting themselves up for the 2020s disappointment.
What-If Scenario: Buying the “Loser”
Comparison: “Dogs of the Dow” Strategy (Buying the worst performers).
| Strategy | Mechanism | Long-Term Result |
|---|---|---|
| Momentum Chasing | Buying yesterday’s winners | Underperformance (Buying at peak valuation) |
| Reversion Trading | Buying yesterday’s losers | Outperformance (Buying at distressed valuation) |
The Cycle of Dominance (Total Return)
| Decade Leader | Cumulative Return (%) |
|---|---|
| 1990s (US Tech) | 417 |
| 2000s (Emerging Mkts) | 162 |
| 2010s (US Large Cap) | 256 |
*Leadership rotates. The dominant asset class changes every decade. Betting on the previous decade’s winner to repeat its performance is statistically a bad bet.
Valuation Spreads (CAPE Ratio)
| Region | CAPE Ratio |
|---|---|
| US Stocks (S&P 500) | 34 |
| International Developed | 15 |
| Emerging Markets | 11 |
*The wider the valuation gap, the stronger the elastic band of Mean Reversion snaps back. Cheap assets (low CAPE) are coiled springs.
Execution Protocol
You cannot predict when the cycle will turn, so you must own everything. Hold a global portfolio (e.g., VT or ACWI) that includes both the expensive US market and cheap International markets. This ensures you never miss the rotation.
Set hard rules. “If US Stocks grow to 65% of my portfolio (target 60%), I will sell the 5% excess and buy International.” This forces you to sell high and buy low without emotion.
S&P 500 is market-cap weighted, meaning it automatically overweights the expensive winners (e.g., Top 7 Tech stocks). Consider “Equal Weight” (RSP) or “Fundamental Weight” ETFs to reduce concentration risk and capture the mean reversion of smaller companies.
COACHING DIRECTIVE
- Do This: Look at your portfolio. If it is 100% US Tech stocks because “that’s what worked,” you are dangerously exposed to Mean Reversion. Diversify into Value, Small Caps, and International.
- Avoid This: Extrapolating the last 3 years of returns into the future. If a fund is up 30% annually, it is not “good”; it is likely “done.”
Frequently Asked Questions
How long does reversion take?
It can take years. Markets can remain irrational (diverged from the mean) for 3-5 years or longer. Mean Reversion is a long-term gravitational force, not a short-term timing signal.
Does this apply to Crypto?
Yes, even more violently. Crypto assets typically experience 80-90% drawdowns after parabolic run-ups. The “halving” cycles are a form of supply-side mean reversion mechanics.
Is Momentum the opposite?
Yes. Momentum works in the short term (6-12 months) because trends persist. Mean Reversion works in the long term (5-10 years) because valuations matter. You can combine them (Dual Momentum) to capture the best of both.