Mean reversion

In One Sentence

In the short run, emotions can push stock prices to absurd levels; in the long run, the money companies actually earn pulls them back.

Why It Matters

Think of Kostolany's "man walking his dog": the little dog (the stock price) darts ahead and lags behind, but its leash is tied to the man (company earnings), who keeps walking forward. I use this idea in one direction only. In a crash, it gives you the courage to add more. After a big run-up, it isn't a reason to sell — a pricey market can stay pricey for years, and the man keeps walking forward the whole time.

One Number

When US stocks rose to more than twice their 10-year average price, the median return over the next 5 years, after inflation, was −3% — so reversion is real. But extremes like that are rare, and even when one comes along, it's hard to beat holding on by selling (Shiller data · author's calculations · Chapter V).

In the Book

Section 4 of Chapter III is devoted to mean reversion and concludes that "a big fall is a chance to add more." The "Buying Low" section of Chapter V returns to the same image and asks you to remember that leash when the market looks frightening.

Go Further

• Buying in crashes What falls a lot tends to rise again — the reason to add more in a crash.
• André Kostolany The "man walking his dog" image comes from him.
• Market cycles What rises a lot falls, and what falls a lot rises: that's the cycle.
• Fear and greed What pulls the dog away from the man is fear and greed.
• "Sell when pricey" backtest A big rise doesn't mean it's time to sell, and the backtests prove it.