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The ninth wonder of the world

(MoneyWatch) The Seven Wonders of the Ancient World is a list of remarkable constructions of antiquity. They are the great pyramid of Giza, hanging gardens of Babylon, temple of Artemis at Ephesus, statue of Zeus at Olympia, mausoleum at Halicarnassus, Colossus of Rhodes and the lighthouse of Alexandria.

Benjamin Franklin is often credited with adding an eighth wonder -- compound interest. The financial world also provides us with a ninth candidate: reversion to the mean (RTM) of abnormal (both high and low) returns. RTM means that when an asset class (or stock) experiences an extended period of abnormally high returns, prices are driven to levels that result in future expected returns being lower. Thus, investors should expect returns to exhibit mean reversion. Similarly, when an asset class experiences an extended period of abnormally low returns, prices are driven to levels that result in future expected returns being higher.

For example, if a 10-year Treasury bond is yielding 10 percent and rates quickly fall to 5 percent, when an investor sells that bond the return would be well above 10 percent. However, future expected returns for investors in that bond are now only 5 percent. Similarly, if a Treasury bond is yielding 5 percent and rates rise to 10 percent, when an investor sells the bond the return would be well below 5 percent, but future returns to holders of that bond would be 10 percent. What once was high is now low and vice versa. That’s reversion to the mean.

Let’s look at an example from the world of equities. For the period 1927-1994, large-cap growth stocks  returned 9.3 percent per annum. Over the following five years (1995-99) they returned 31.3 percent per annum. The effect on valuations (and, therefore, on future expected returns) can be seen by looking at the P/E ratio of the S&P 500 Barra Growth Index. At the end of 1994, the P/E ratio stood at about 19. By the end of 1999, the P/E ratio had risen to 54! One dollar invested in this asset class at year-end 1994 would have grown to $3.90 in just five short years (the eighth wonder of the world, compound interest, at work).

It is important to note that these great returns did not come right after a period of poor returns. In the preceding 10 years, large-cap growth stocks returned 14.8 percent. Remember, a period of low returns would lead us to expect higher future returns. However, in the 10 years leading up to 1995, large-cap growth stocks provided returns that were well above the historical average — about 76 percent higher than the return of 8.4 percent they had delivered from 1927-84. This example demonstrates the point that while we should expect returns to revert to their mean, there is no way to know when they will do so — returns can remain abnormally high or low for a long time. This makes trying to time the market and avoid (or catch) a mean reversion a losing proposition.

While we cannot know when it will happen, we do know that returns will almost certainly exhibit the tendency to revert to their mean. And in the case of large-cap growth stocks, they surely did. In the RTM that occurred from 2000 through 2009, they lost 3.5 percent per annum, producing a total loss of 30.2 percent.

The sad news is that far too many investors are unaware of this ninth wonder of the world. In fact, as we have discussed, investor behavior tends to exhibit the trait known as recency — an investment trait that most often dooms investors to poor outcomes. The result is that investors follow a strategy of buying high and selling low — not exactly a recipe for investment success.

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