Are we on an investment cliff? Itâ€™s in our nature to assume that current trends â€“ whether good or bad â€“ will continue. But itâ€™s important to keep in mind that the market is random. Predicting its future from the recent past is less than accurate. Thatâ€™s where the statistical principle, regression to the mean, comes in.
We know from the study of Neuroeconomics that it is human nature to assume trends will continue. What we see now is fresh in our mind. Thus, we tend to make predictions that are based on a correlation with the immediate past. If the market is going up, it seems there is no end to the anticipation that it will continue. On the reverse side, if it is steadily going down, there is an expectation that it will remain in that trend. This phenomenon is known as a representativeness heuristic, an easy rule of thumb when making a decision under uncertainly. It was coined by psychologists Amos Tversky and Daniel Kahneman in the early 1970s
However, predicting future market movement from the immediate past is less than accurate because the market is random. It doesn’t follow a specific pattern that can be anticipated. In fact, to some, it appears more irrational than rational.
Enter, the statistical principle, regression to the mean, which brings logic to stock market decisions. Regression to the mean is the tendency of a variable to move away from extreme values toward the average. Understanding this principle can be of benefit to help prepare for the unknown, whichever way the stock market is heading since no one can predict this with 100 percent certainty.
Here is one option to keep your investments on target. Look for dramatic winners over the last one or more years. Then, pare down their positions to get ready for regression to the mean. This does not necessarily mean selling the total position. It simply suggests trimming. Portfolio managers call this portfolio rebalancing.
For example, Johnson and Johnson (symbol J&J) has been on a tear. Since 2012, it has doubled in price. This outstanding performance is unlikely to continue, whether due to an across the board stock market drop or unexpected adverse news about J&J. Therefore, those who are fortunate enough to hold J&J may want to consider selling a part of their position, probably no more than half since this is a blue-chip stock plus the upward momentum may continue.
The stock performance of J&J over the last ten years. It has roughly doubled since mid-2012. From YahooFinance.com.
Many other stocks and mutual funds plus exchange traded funds have likewise done spectacularly. For those readers who have a managed portfolio, the manager is likely doing portfolio rebalancing. I find, though, it is always good to check.
For those who are self-managing their investments, consider it time to rebalance if it hasn’t been done already. An hour or so now could lead to less worry about a toppy portfolio dropping in value. Additionally, it could potentially lead to bigger profits later if gains gleaned from the top or near top are re-invested into less expensive options if the market does tumble.