Mean Reversion & The Naïve College Scout
In this article, Max Knape breaks down the concept of mean reversion. What does so called naïve investors have in common with college scouts? More than you’d think. Read the article to get the full story.
Full disclosure; I’m personally a strong believer in the concept of mean reversion. Described as the force that prevents a prolonged trend from deviating too far away from its historical average, mean reversion is the fundamental belief that allows my firm to invest against the tide, in securities out-of-favor with the masses. In this article I dive into why mean reversion exists, how it works, as well as its effect beyond financial markets.
Behavioral science researchers Lakonishok, Shleifer, and Vishny (“LSV”) in their 1994 paper, “Contrarian Investment, Extrapolation, and Risk” argue that out-of-favor stocks generate better returns since they are contrarian to the behaviorally suboptimal strategies followed by “naïve” investors. The reason, they postulate, is because so called “naïve” investors form expectations about the future performance and growth potential of stocks without a full appreciation for the phenomenon of mean reversion.
“Naïve” investors tend to avoid stocks that have done poorly in the past, expecting they will continue to do poorly in the future, and instead focus on stocks that have done well in the past, assuming they will continue to perform well in the future. With a vast trove of academic research pointing towards the foolishness of such suboptimal behavior, why do naïve investors continue to purchase securities that have done well in the past? And, why does mean reversion prevent these stocks from, on average, doing well in the future? While some academics theorize that the mean reverting properties of these stocks is simply a display of increased competition, collectively forcing prices and profits down towards the historical average, others argue that the forces behind mean reversion cannot be explained. The latter, was perhaps most notably expressed by Ben Graham, the founding father of value investing, in his congressional hearing in 1955 where he stated;
“[Mean reversion] is one of the mysteries of our business, and it is a mystery to me as well as to everybody else.”
To illustrate the concept of mean reversion and how its forces work outside of financial markets, let us look my dear partner, Samuel Frymier’s favorite example. Namely, that involving a high school basketball player and a naïve college scout. For the 40 games played during his Freshmen and Sophomore year, the player made 25% of three-point shots. In the beginning of Junior year, the player does well, averaging 80% from the three-point line for his first four games. By coincidence, a naïve college scout decides to come watch him play in the fifth game. Again, the player does exceptionally well, shooting 81% from the three-point line, which maintains his season average. Much like the way “naïve” investors overextrapolate short-term price or earnings trends too far into the future, the “naïve” scout, thinking that the player’s recent past will continue for the foreseeable future, forms expectations about the future performance potential of the player, only to realize that the players true average from the three-point line was a shy 31.13%.
In basketball, mean reversion forces player performance back to their long-term historical average. In financial markets, that same force manifests in investors extrapolating past earnings performance too far into the future, or simply assuming a trend in stock prices will persist. Whatever the reason, investors tend to get overly excited about stocks that have done well in the recent past and bid them up so that these stocks become overpriced. They also overreact to stocks that have done poorly, oversell them, and these out-of-favor stocks become undervalued. At Quesne Capital, part of our process exploits these behavioral errors, investing in undervalued stocks on the expectation that they will revert to the mean and, consequently, beat the average market return.
This article was written by Max Knape who is a co-founder and managing partner of Quesne Capital. Quesne Capital is a sub-advisor to KFF. More information on their firm can be found at http://Quesnecapital.com
Lakonishok, Josef, Andrei Shleifer, and Robert W Vishny. 1994. “Contrarian Investment, Extrapolation, and Risk.” Journal of Finance 49 (5): 1541-1578. Canarella, Giorgio and Miller, Stephen M. and Nourayi, Mahmoud M., Firm Profitability: Mean-Reverting or Random-Walk Behavior? (February 24, 2012). Journal of Economics and Business, March-April 2013.
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