Reversion to the Mean and TIME
Good Morning Relaxing Retirement Subscriber,
Everyone craves order and certainty. We like it when we understand cause and effect.
We like it when there is a simple and logical explanation for why something occurred.
X happened because Y went this way and Z went that way.
This is a very common desire among investors as well. When markets move sharply in one direction or another, many investors, craving order and certainty, demand to know “the” reason.
The challenge with this line of questioning is there are tens of billions of shares of stock traded every day throughout the world by millions of market participants.
While it would be convenient if there was one “reason”, there never has been and there never will be one reason which explains why market prices move the way they do in the short run.
However, there are clear reasons why market prices move the way they do in the long run. And, this is a key understanding among successful investors.
Reversion to the Mean
Vanguard founder and index fund pioneer John Bogle once said, “reversion to the mean is the iron rule of financial markets.”
What exactly did he mean and why is it so important for you to understand?
Essentially, if you plotted the various short-term returns of a globally diversified equity portfolio, you would discover several things:
- Prices move wildly and randomly on a daily basis.
- There is a bell-shaped distribution of returns with a very large percentage of daily returns falling within a very small, concentrated range.
- And, a small percentage of returns falling outside of that heavy concentration of returns.
What this demonstrates is that, despite short-term movements outside of the “normal” distribution of returns, market prices eventually gravitate back toward the very long historical mean.
What this means for you is investing is a long-term process and you must use time to your advantage. In the short-term, prices move wildly and randomly and they don’t appear to make much sense.
In the long run, however, they make perfect sense and prices tend to revert to the mean. We simply have to have a workable investment system and strategy in place to deal with short-term market volatility and hang in there long enough to capture rational long-term returns.
There’s a choice to make in response to wild and random short-term market price movement: kneejerk reaction and panic or calm and rational system and strategy.
Committed To Your Relaxing Retirement,
The Retirement Coach
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(The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)