Investors have a tendency to want to buy hot stocks, which are stocks that have performed extraordinarily well in the recent past, beating most indices and the market in general. It is easy to turn your TV on and find that some “stock market expert” is giving his picks on which stocks you should buy and sell at a given moment. Many investors, particularly unsophisticated ones, like to listen to this kind of information and act accordingly. This is a bad idea and it is explained by a simple concept called “regression to the mean.”
Regression to the mean is the tendency for things to even out over time. Extraordinary performance, good or bad, will tend to get closer to the average as time passes. Regression does not mean that a company that has been beating the market for a few years all of a sudden will have extremely bad performance in order for the returns to even out, but it does imply that its performance will most likely not be as extraordinary as it had been and its average return will match the market’s average return. As they say, past performance is not a good indicator of future performance.
People underestimate the role of luck in picking stocks. Investment professionals like to attribute exceptional returns in a given year to their skill, while in reality the main factor in their success can be luck. Luck plays an important role in performance, especially in the short term. An investor can have good luck and beat the market this year or, conversely, have bad luck and underperform the market. However, due to regression to the mean, it is very unlikely that their good or bad luck will continue in the long term, which brings their overall return closer to the average return of the market.
To see regression to the mean at work in the stock market, let’s talk about Apple. In 2008, Apple had a negative return of 56.91%, 26 percentage points lower than the average return of stocks in the Dow Jones Industrial Average, which would have caused your favorite stock picker to tell you to sell that stock or avoid buying it. However, in 2009, Apple returned 146.9% to its shareholders, leading the Dow in performance and beating the benchmark by 128 percentage points. Again, in 2012, Apple had a 31.4% return, 18 percentage points higher than the average stock in the Dow. In this case, you would have been told to buy Apple, which again underperformed in 2013, finishing the year with a 5.42% return, 24 percentage points lower than the average stock in the Dow.
You shouldn’t believe what “stock market experts” on TV tell you. Next time, when you stumble upon Jim Cramer don’t put any weight on the advice he gives about which stocks to buy and sell, rather watch the show for entertainment. In the long run, you will be better off investing in index funds that mirror the stock market, as you will take luck out of the picture and let regression to the mean take care of the market fluctuations.
Oscar Nieves is a student in Joe McGarrity’s Senior Seminar class at the University of Central Arkansas. Joe McGarrity, a professor of economics at UCA and a regular columnist, has vetted the article. You can reach Professor McGarrity at firstname.lastname@example.org.