IT MIGHT SEEM LIKE an obscure academic question: Do stocks truly follow a random walk or can we count on them reverting to the mean? Depending on which side we favor in this debate, it can make a huge difference to how we invest—and to our confidence as investors.
Like me, many HumbleDollar readers have most or all their investment dollars in index funds. A key reason we invest this way: It’s impossible to predict which stocks will shine because they follow a random walk. In other words, what happens to share prices on Monday tells us nothing about Tuesday, because Tuesday’s price movements will be driven by news that, by definition, isn’t yet known. The upshot: Our best bet is to diversify broadly and at the lowest possible cost, which is what index funds allow us to do.
But I suspect that—again like me—many HumbleDollar readers also believe that markets mean revert. If the stock market plunges this year, we feel that improves the odds that stocks will fare better next year and thus we don’t believe share price movements are completely random. Without this sort of conviction, it would be hard to ride out a major market decline. After all, if we couldn’t count on stock prices bouncing back, why shouldn’t we panic and sell?
It might seem contradictory to assume that the daily movement of individual stocks is random, while also assuming that the overall market reverts to the mean. But I think both beliefs are reasonable. We know it’s extraordinarily difficult to pick stocks that beat the market averages. For proof, look no further than the dismal performance of most actively managed mutual funds. But at the same time, there’s evidence that bad times in the broad market are followed by good.
When some investors use the phrase “reversion to the mean,” they use it in a strict sense, believing that the overall market always reverts to some average historical valuation or some average rate of return. But I don’t pretend to know what the market’s “mean” is. I don’t think there’s any guarantee that stocks will notch 10% a year, no matter how long we hold them, nor do I think the U.S. market is destined to revert to, say, its 100-year average of 17 times trailing 12-month reported earnings, with a dividend yield of 3.9%. (Today, stocks trade at 44 times earnings and yield 1.4%.)
But I do firmly believe that, when stocks next plunge, good times will return. Why? The stock market’s performance roughly reflects the economy. As the economy grows over time, corporate earnings will increase. In the short term, investors may be more concerned about, say, rising interest rates, political upheaval, accelerating inflation or higher taxes. But sooner or later, they’ll take note of those rising corporate profits and bid up share prices.
What are the investment implications? Instead of panicking when stocks plunge, we ought to feel confident that our portfolio will come back. But our degree of confidence should vary with our investment strategy.
If we own the broad stock market through, say, total market index funds, we know our portfolio will rebound along with the market. That means that, when stocks next nosedive, we should be prepared to rebalance our portfolio, adding to our total stock market index funds, so we maintain our portfolio’s target stock percentage. This will strike some as heresy, but I think that—if a market crash is severe enough—going even further, and overweighting stocks, is a reasonable strategy.
That said, we shouldn’t expect almost immediate gratification, like that enjoyed by those who bought in late February and early March 2020. The recovery from the next stock market crash may take far longer than we would like. Remember 2000-02? U.S. stocks suffered three consecutive losing years. Markets ought to return to their previous all-time highs, but it doesn’t mean they’ll do it quickly.
What if we’re overweighted in, say, growth stocks or value stocks? We can still be confident—but perhaps not so much. In a broad market rally, both growth and value stocks will gain, but there can be big differences in performance. Ditto for large and small stocks, and U.S. and international.
In other words, during a stock market decline, rebalancing from bonds and cash investments to the broad stock market is likely to pay off. But if value stocks outpace growth stocks in any given calendar year, which seems likely in 2021, rebalancing at year-end from value to growth could hurt results. To be sure, if the performance gap is large enough and it goes on for long enough, mean reversion among market segments ought to happen eventually. But different segments of the global stock market can stay out of favor for a decade at a time, as we saw over the past 10 years, when U.S. large-company growth stocks soared, while value stocks, smaller companies and international markets struggled.
One implication: We should be slow to rebalance such market segments. For instance, I have a small-cap value index fund, which—after a long period of lackluster performance—has finally started generating decent returns. I’m in no hurry to lighten up on small-cap value and rebalance back to my target percentage because I figure this trend could run for many years.
What about individual stocks? While the entire stock market and broad market segments should revert to the mean, there are no guarantees with individual companies. In fact, history tells us that most companies suffer subpar stock market performance and have very short lives. The upshot: If you own an individual stock that’s struggling, I’d think long and hard before doubling down. Instead, I’d ask whether the market knows something about the company’s prospects that you don’t—and whether the wise move would be to sell and move the proceeds into a broadly diversified fund.