The Law of Mean Reversion & Investment Decisions

You are probably aware about the law of mean reversion. Explain this concept in relation to Mutual funds. How this information can be used to select the Mutual funds schemes.

Ans.

Let’s break down the Law of Mean Reversion using a simple, real-life example related to mutual funds to clarify the concept.

What is Mean Reversion?

Mean reversion suggests that over time, things tend to return to their average state. For mutual funds, this means that after a period of extreme performance (either good or bad), a fund's returns are likely to settle back toward its historical average.

Example of Mean Reversion in Mutual Funds

Let’s say there are two mutual funds, Fund A and Fund B. Over the past 10 years:

Fund A has historically provided an average return of 10% per year.

Fund B has also averaged around 10% per year.

Scenario 1: Outperformance (Above Average)

In the last 2 years, due to market conditions or a hot sector (e.g., tech stocks), Fund A has generated a 30% return each year. Many investors might flock to this fund, thinking it will continue to deliver such high returns.

However, due to the law of mean reversion, we know that it is unlikely for this fund to continue giving 30% returns in the long term. Eventually, the returns will likely come back down closer to its historical average of 10%. So, next year, Fund A might deliver only 5% or 8%—closer to the long-term average.

Investor Takeaway: If you invest in Fund A expecting it to keep generating 30% returns, you might be disappointed when it eventually reverts to its historical mean of 10%.

Scenario 2: Underperformance (Below Average)

In contrast, Fund B has had a tough 2 years, with negative market conditions affecting its sectors (e.g., energy or financial stocks). Its returns have been -5% each year. Many investors might sell off this fund, assuming it will continue to perform poorly.

However, based on the law of mean reversion, we can expect that Fund B will likely return to its long-term average of 10% once market conditions normalize. The poor returns are temporary, and in the coming years, the fund could deliver much stronger returns, possibly higher than 10% as it catches up.

Investor Takeaway: Instead of avoiding Fund B because of its recent poor performance, you might consider it an opportunity to buy into a fund that will likely rebound, eventually reverting to its historical average.

How to Use Mean Reversion in Mutual Fund Selection

1. Don't Chase Recent Winners: If a mutual fund has had an unusually high recent performance, it’s important to remember that such performance is unlikely to continue indefinitely. The fund is likely to revert to its average performance over time.

2. Consider Underperformers: Funds that have underperformed for a couple of years may present a buying opportunity, as they may rebound and revert to their historical average returns.

3. Long-Term Focus: Instead of focusing on short-term fluctuations, look at the 10-year average return of a mutual fund. A good fund might underperform for a year or two but over time, it should move back to its average returns.

Practical Tip:

Before investing, instead of just looking at the 1-year or 2-year performance, check the 5-year or 10-year performance. This gives you a sense of the fund’s long-term average return and helps you understand how far it might deviate from that average.

By using the concept of mean reversion, you can avoid common mistakes like chasing high performers or giving up on underperformers too soon. It helps you focus on long-term, more predictable outcomes.