Mean Reversion Cycles

The Journal of Finance. Werner F. M. De Bondt, Richard Thaler.

Average of 16 Three - Year Periods Between January 1933 and December 1980. Length of Formation period: Three Years. Cumulative Average Residuals for Winner and Loser Portfolio of 35 stocks (1-36 months) into test period.

We read about the McGregor’s X and Y theory. X theory suggesting that people need to be blamed and Y is about self motivated people. How could you rebuke people and get results out? The psychologist Daniel Kahneman, winner of the 2002 Nobel Prize in economics, pointed out that regression to the mean might explain why rebukes can seem to improve performance, while praise seems to backfire. This explained why the X theory leaders delivered.

Behavioral finance (B) case where losers outperformed compared to winners over longer period of times is just another extension of the mean reversion theory. If it was not for mean reversion B may never have become main stream. It was mean reversion which actually allowed the subject to crack open the 250 year old classical economics armor. How?

Historically, economists and statisticians have seen randomness and patterns together. Very few attempted to explain this phenomenon. Jacob Bernoulli’s (1654-1705) work on the Law of large numbers talked about probabilistic fate (order) in random events. Abraham de Moivre (1667-1754) probability became ‘The doctrine of chances’. Pierre-Simon Laplace (1749-1827) who created the method of least squares gave a pattern to a set of probabilistic observations. Francis Galton (1822-1911), built on the idea and wrote about mean reversion.

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This article is written for Business Standard

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