Monday, August 24, 2009

Regression to the Mean and Investing

Sir Francis Galton, cousin of Charles Darwin, first identified regression to the mean in his 19th century publication Regression towards mediocrity in hereditary stature. Simply put, it indicates that, left to themselves, things tend to return to normal, whatever that is. Thus when the price of stocks, as represented by the Dow-Jones Industrial 30, declines to a level that is significantly below the long term trend or mean, investors are provided an opportunity to buy low now and sell high later.

Between 1929 and 2007, the Dow 30 grew at a compound annual rate of 5.2%. From December 2007 until August 2009, the Dow 30 plummeted at an annual rate of 14%. In order to return, or regress, to the mean the Dow 30 would have to soar to 14,690. Thus buying the Dow 30 via the Diamonds (DIA) should provide investors with a substantial financial reward, assuming a return to trend.

There is certainly no guarantee when this will happen and there are three reasons that regression to the mean may be a frustrating guide to decision making. 1) It proceeds so slowly that a shock disrupts the process. 2) The regression may be so strong that it “punches through” the trend or mean, 3) The mean may be unstable. Nonetheless, statistically speaking, stocks are currently priced for the buyer, not the seller.
Ernie Goss

1 comment:

Finance Information said...

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