Peapods and Perils

Presented by: Rajan Thakur

FIN 700
3 reasons why regression to the mean failed to
forecasting in the market.

 It sometimes proceeds at so slow a place

that a shock will disrupt the process.
 Regression may fluctuate around the
mean, with repeated, irregular deviations
on either side.
 The mean itself is unstable, the normality
may change in the future.
Normal had shifted to a new location

 In 1930, right after the Great Crash, stock prices

had fallen 50% from their previous high in 1929.
 Prices proceeded to fallen another 80% before
they finally hit bottom in 1932.
 Take another look at the market in 1955, DJI
gradually regain its 1929 high in the preceding 6
years.
 After 9 years, in 1964, the DJI was doubled.
 An interesting paper
 Title: “Does the Stock Market Overreact? ”
 By: Richard Thaler and Werner Debondt
 Main issue: to test whether extreme
movements of stock price in one direction
provoke regression to the mean and are
subsequently followed by movements in
other direction.
 An interesting paper
 Studied 3-year returns of thousands of stock from
January 1926 to December 1982.
 Classify stocks: Winners VS Losers.
 Calculate average performance of each group.
 Finding: Loser group outperform the market average by
19.6% and Winner group earn 5% less than the market.
 Conclusion: Investors overreact to the new information
made the unequivocal result.
 The reasons: focus on the short-run and ignorance the
long-run, which is regression to the mean.
 An vivid evidence of regression to
the mean
 1994, Morningstar, (A leading publication
on performance of mutual funds)
published accompanying table.
 A spectacular demonstrate of regression
to the mean.
 It was not the fault of the fund managers,
but was the swing in different industry.
 Various funds fare over the 5 year
ending March 1989 and March 1994
Objective 5 year to March 1989 5 year to March 1994
International stock 20.60% 9.40%
Income 14.30% 11.20%
Growth and Income 14.20% 11.90%
Growth 13.30% 13.90%
Small company 10.30% 15.90%
Aggressive growth 8.90% 16.10%
Average 13.60% 13.10%
 Test the market as a whole
 The stock-prices movement in the short
run are independent.
 But the performance by the month and by
the quarter still look like a normal
distribution.
Test the market as a whole
 A simple logical reasoning:
if the random-walk view is correct
Prerequisite:
 Today’s stock price embody all relevant
information.
 The availability of new information would be the
only thing that make stock price change
 A simple logical reasoning:
if the random-walk view is correct
Reasoning process
 No way of knowing what new information might be
↓
 No mean for stock price to regress
↓
 No temporary stock price (A price sits in limbo before
moving to another point.)
↓
 Stock price changes are unpredictable.
William Reichenstein and Dovalee Dorsett

 Professor of Baylor University

 Published a monograph in 1995 by Association
for Investment Management & Research.
 Their conclude: Bad periods in the market are
predictably followed by good periods, and vice
versa.
 This finding directly contradiction to the view
random-walk view.
 Ignoring short-term volatility
 In a very long run, return to investors should average
around some kind of long-term normal.
 Stock market may be risky for some months or even
certain years, but the risk of losing substantial over a
period of 5 years or longer should be small.
 Long-run volatility in the stock market is less than it
would be if the extremes had any chance of taking over.
 Uncertainty about rate of return over long-run is much
smaller than in the short run.
 The paradox
 We, people, are obliged to live in the short run.

 Most of us believe is inevitably wrong. But without

conventional wisdom, we could make no long-run
decisions and would have trouble finding our way from
day to day.

 In the long run, we are all dead. Economists set

themselves too easy, too useless a task if in the
tempestuous seasons they can only tell us that when the
storm is long past the ocean will be flat.
---John Maynard Keynes
 Conclusion
 Regression to the mean is only a tool; It is
not a religion with immutable dogma and
ceremonies.
 Regression to the mean is little more than
mumbo-jumbo.
 Revel in more comprehensive views than
the average.
Any Questions?