Investing: Mean Revision

          I suspect that a lot of people who skim blogs like this will probably jump right past this topic, and others may get a little intimidated just by the boring name “mean revision”.  However, understanding this very simple concept will put you ahead of 99% of the people around you trying to retire with some dignity.

          As I have tried to drill into this book 100x times, no one knows the future, therefore, no one can have any special skill in selecting only investments that garner the highest return.  Otherwise, why would they have more than one investment in their portfolio?  Just buy the one that is going to do the best, everything else is a waste of money.  Mean revision is the cousin of predicting the future.

          Mutual funds, explained elsewhere in this book, are either set to match an index such as the DJIA or S&P 500, are industry specific, or are “professionally” managed.  That is, the manager does research to find the “best” stocks and cherry picks only the one’s he or she feels will do the best.  Hundreds, or even thousands of these funds are opened every year, and most of them close down in a short time due to under-performance.  However, sometimes these funds actually do well, making a return higher than the index.  Of course, this piques the interest of investors who flock into this over-performing fund.  The manager, who now has to invest this additional money, may or may not do as well with additional selections, or the selections initially made may not continue performing well.

          What happens next is that the fund begins to under-perform the market.  Of course, all of the people who poured into the fund before leave, chasing their next fix of supposedly superior returns.  The fund may or may not survive this.

          So essentially, mean revision is where a fund first achieves “alpha” or superior investment returns, followed by lower than average returns that put the overall average return of the fund to the average of the market.  This is typically achieved with managers attempting to outperform the market with their special “skills”. 

          As normal people with normal jobs, and (probably at best) 15% of our incomes going to retirement investing, we are not going to be able to afford a manager who actually can consistently outperform the market.  It would not even be enough if us normal people could magically hand over our entire lifetime income at birth to these professionals.  In terms of the stock market, it is best to simply ride the market averages rather than deal with snake oil salesmen promising the world.

          So, what to do when looking at mutual funds?  Look for the funds that have the broadest investment philosophy.  That is, a fund that invests in all of the biggest stocks, or all of the middle-sized stocks.  From there, look for a fund that has as little “churn” as possible.  That is, a fund that is not constantly trading in and out of stocks.  That costs money and rarely helps the overall return on investment. 

Finally, and most importantly, look for the lowest fees.  You are at best going to get the same return as the market, so doing so as cheaply as possible ensures that you keep more of your investment returns.  High fees are nothing to brag about, and higher fees will not guarantee a higher return.  They will only guarantee more of your money not being invested on your behalf.  That does not help you.