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RTM~Bogleview
Old 11-26-2005, 11:52 AM   #1
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RTM~Bogleview

"REVERSION TO THE MEAN:

Clearly Sir Isaac Newton's revenge on Wall Street is at work here! Reversion to the mean. Again! What goes up (above the market mean) must go down (below the market mean). This law of gravity which affects all broad classes of stocks (large vs. small, U.S. vs. international, etc.) is the classic manifestation of the eternal dynamics of the stock market's extraordinary ability to arbitrage present reality against future expectations.

RTM may take place slowly or quickly; it may take place in spasms or over cycles; but take place it does. And it can correct long-standing imbalances in a trice. For example, the reversion to the mean that took place last year, up with Value, down with Growth, brought these two market segments almost to equivalence since 1989, the second year of the 11-year ascendancy for growth stocks. The record for that period now shows annual returns of +16.6% for Growth, and +15.4% for Value.

In the very long run, the cycles have ironed themselves out and, at least in my view, there is no reason to expect either style to outpace the other over time (despite the important tax advantage for the growth investor). And the 1937-2000 record is witness to the profound pervasiveness of RTM. Despite all the cycles, the record for the past 63 years shows these annual rates of return: Growth, +11.8%; Value, +11.9%. Now to be sure, some brilliant academics disagree with my conclusion. In their seminal 1992 paper, Professors Fama and French showed that low p/e, low market-to-book stocks had provided higher returns than high p/e, high market-to-book stocks. But I would observe that their study, which covered the period 1963-1990, shares a common limitation with every other study of investment returns that has ever been undertaken. It was period dependent. And it happens to have coincided quite neatly with the era of Value investing that took place from 1968 through 1989. Yet for ten long years following their study, it was Growth that, by a wide margin, sat in the drivers? seat.

I'm a firm believer that RTM is a pervasive investment principle. So place me in the camp of those who believe that neither strategy, Growth or Value, has an inherent long-term edge. Neither strategy, then, has the durability of a star. Both are comets. comets with long tails, but comets nonetheless. Yet as we observe these extended cycles of mean reversion, it must occur to you that investors ought to be able to capitalize on them, riding one horse until it tires, then leaping to the other.

Sad to say, too many mutual funds and mutual fund investors are doing the exact reverse of that strategy, waiting nervously as the cycle develops, finally succumbing to temptation and jumping aboard as it approaches its peak, only to suffer the consequences when the seemingly inevitable RTM takes place. And doing the reverse takes more courage and foresight than most of us have. Speaking for myself, I have the ability to forecast neither how much of this recent reversion to the mean in favor of Value remains, nor when it will end. If you are smart enough to know, please be my guest and act accordingly. Good luck!" J.Bogle

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Re: RTM~Bogleview
Old 11-26-2005, 01:48 PM   #2
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Re: RTM~Bogleview

I'm really surprised this comes from Bogle. I usually agree with what he writes. But RTM is simply an observation that noisy data will rise and fall above the mean of that data. The thing that so many observers of this phenomena seem to miss is that the mean changes too. Each year a new data point is added and the mean is recalculated. In years with higher than mean values, the mean rises. String several above average years together and the mean rises more. If instead of calculating a single value of PE (or any other indicator) you calculate and plot PE for each year, you notice a significant upward trend throughout history. Fit that trend to a straight line (instead of using a constant mean value) and apply RTM thinking and you will come up with different predictions. Fit it to an nth order polynomial and you come up with something even different. Use PE10 or PE30 and you will get even different predictions. Since RTM is simply an empirical observation without any causal theoretical justification, there is no way to judge if any of these mathematical empirical curve fits has any meaning for the future. Good luck with that.
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Re: RTM~Bogleview
Old 11-26-2005, 07:49 PM   #3
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Re: RTM~Bogleview

Quote:
Originally Posted by ((^+^)) SG
Since RTM is simply an empirical observation without any causal theoretical justification, there is no way to judge if any of these mathematical empirical curve fits has any meaning for the future.* Good luck with that.* *
So even after reversion to the mean, the mean itself has to revert to an even lower mean?

Gosh, we really are in trouble!!

The stock market has been going up three-quarters of the time for over two centuries. That must mean that it'll spend the next 150 years going down...
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Re: RTM~Bogleview
Old 11-26-2005, 08:04 PM   #4
 
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Re: RTM~Bogleview

What is amusing to me, is that no matter what happens, the pundits will come out in force to claim that 'they' predicted it.

If the market gains 4,000 points there will be a plethorea of articles that said the rise was obvious for the following reasons. Likewise, most of these same pundits would also proclaim that it was equally obvious if the market took a nose dive of 4,000 points.

I don't think it would be too difficult to find a lot of articles that said that the Dow should be around 5,000 points back in 2001. Should we all have taken our money out of the market and wait for the Dow to hit 5,000 before jumping back in?

Harry Dent has written a book proclaiming that the Dow should be around 25,000 by now! - these are not stupid people! - How can they be in such disagreement?
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Re: RTM~Bogleview
Old 11-26-2005, 09:20 PM   #5
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Re: RTM~Bogleview

Quote:
Originally Posted by Cut-Throat
If the market gains 4,000 points there will be a plethorea of articles that said the rise was obvious for the following reasons. Likewise, most of these same pundits would also proclaim that it was equally obvious if the market took a nose dive of 4,000 points.
What scares me is that sometimes it's the same people...
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Re: RTM~Bogleview
Old 11-26-2005, 09:44 PM   #6
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Re: RTM~Bogleview

Quote:
Originally Posted by Cut-Throat
...these are not stupid people! - How can they be in such disagreement?
It's because there are so many variables that go into making the economy what it is that it is impossible to predict the significance of how each of those variables will affect the others.

There are all kinds of variables including population growth, fashion trends, interest rates (long and short), inventory levels, tax rates, wars, new technology, exports and imports, social policies, politics, etc, etc, etc.

In the end, our success boils down to 3 main things:* Risk tolerance, Luck, and Faith.

Your risk tolerance will either enable you to invest in more things that can cause you to fail more or succeed more than the person who is just going to put money in treasuries.

Luck can only be determined in hindsight when you can look back and figure out you either got in or out of the right investment at the right time (like the dot coms).

And faith, well we all have to believe that the world as we know it will remain as we know it.* Empires have collapsed, kingdoms have disappeared, and there have been world-changing catastrophes like the one that caused dinosaurs to become extinct.
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Re: RTM~Bogleview
Old 11-27-2005, 03:15 AM   #7
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Re: RTM~Bogleview

Quote:
Originally Posted by retire@40
It's because there are so many variables that go into making the economy what it is that it is impossible to predict the significance of how each of those variable will affect the others.
I totally agree. We now have much more of a global economy which adds layers of complexity. I keep hearing how we as a nation now understand inflation/deflation and can control it by simply raising and lowering the lending rates. It seems too simple of a solution for such a complex system. I believe we will be served some humble pie before long.

I think the next chairman of the Federal Reserve is going to earn his paultry salary.

-helen
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Re: RTM~Bogleview
Old 11-27-2005, 07:23 AM   #8
 
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Re: RTM~Bogleview

Quote:
Originally Posted by retire@40
It's because there are so many variables that go into making the economy what it is that it is impossible to predict the significance of how each of those variable will affect the others.
My question was more rhetorical, than anything. What I was really asking was 'How come these 'smart' people think they can predict the future? Especially when their colleagues, come up with an entirely different prediction!

Are they trying to fool themselves or their readers?
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Re: RTM~Bogleview
Old 11-27-2005, 08:06 AM   #9
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Re: RTM~Bogleview

Quote:
Originally Posted by Cut-Throat
My question was more rhetorical, than anything. What I was really asking was 'How come these 'smart' people think they can predict the future? Especially when their colleagues, come up with an entirely different prediction!

Are they trying to fool themselves or their readers?
They are simply trying to sell books/speaking engagements to make money. Since there is no personal financial consequence for the accuracy of their predictions (think you would win a suit against them for "wrongful predictions"? ), what do they have to lose other than the risk of being wrong?

Then they publish a new book saying "This time I'm right", create new controversy, sell more books, etc. Rinse and repeat.

But if by some strange coincidence, they get it right, then they've just won the lottery....until their next predition is wrong. See above.


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Re: RTM~Bogleview
Old 11-27-2005, 09:44 AM   #10
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Re: RTM~Bogleview

Quote:
Originally Posted by REWahoo!
They are simply trying to sell books/speaking engagements to make money.* Since there is no personal financial consequence for the accuracy of their predictions (think you would win a suit against them for "wrongful predictions"? ), what do they have to lose other than the risk of being wrong?

Then they publish a new book saying "This time I'm right", create new controversy, sell more books, etc.* Rinse and repeat.

But if by some strange coincidence, they get it right, then they've just won the lottery....until their next predition is wrong.* See above.


Ding! Ding!* We have a winner.* Sell those books!* Make those speeches.* Sing to the choir, as long as the choir coughs up some money.

I know I'm right!*
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Re: RTM~Bogleview
Old 11-27-2005, 12:08 PM   #11
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Re: RTM~Bogleview

Quote:
Originally Posted by Eagle43
Ding! Ding!* We have a winner.* Sell those books!* Make those speeches.* Sing to the choir, as long as the choir coughs up some money.

I know I'm right!*


I saw a book at Barnes & Noble titled "How Buffett does it" I thought to myself "If James Pardoe really knew how Buffett did it, and it was really replicable, Mr. Pardoe would be a billionaire and the book would instead be titled "How Pardoe does it"
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