Mean Reversion Made Simple
This paper provides simple context to what are often difficult and highly emotional decisions around money. KCR spent much of 2020 and 2021 producing evidence that the valuations of popular fast growth stocks would lead to their demise. Since the peak in 2021, stock speculation has gone from popular to perilous as mean reversion took its toll.
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More recently, our work Tesla Price to Sales Ratio & The Tax on Index Funds and the Vanguard Small Cap Index Fund has shifted readers’ focus to the unprecedented risks in Large Cap Core Funds. KCR’s team believes that the importance of engaging with low-cost process driven active managers has never been higher. As those pieces highlighted, the risk to mean reversion on valuations has created unusually high risks for index fund investors.
The chart below shows the following three pieces of data:
- First bar: the long-run annual return to the US stock market from 1871 – 2022 is 9.1%[i]
- Second bar: shows that from 2009 – 2021, the market returned 16.0% per year for 13 years
- Third bar: shows that in the five years from 2017 – 2021, the market averaged 18.4% per year
The conclusion is clear: this is not sustainable. The market has outperformed historical returns by a wide margin since 2009. Much of this outsized performance came in the 2017 – 2021 period when returns were 2x higher than long-term historical average.