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Friday 25 March 2016

Meme Reversion

500 and Counting

I’m now about 500 posts and a million words into the back-to-front world of financial psychology and you might think I'd have learned something useful by now. Well, it turns out there are only a couple of things you need to bear in mind: that mean reversion is the only certain thing about markets and that (almost) no one is interested.

The reason that no one is interested is that everyone is convinced that they can identify the narrative, the story, the meme that will find the next wonder stock that defies the law of mean reversion. And you might, but the chances are you still won't become filthy rich on the back of it, because only in hindsight is success inevitable. 

Is it a bird?

Gravity defying superstocks do occur from time to time, companies which happen upon some moat, establish their business and then successfully defend their margins against all and sundry. Of course, even superstocks eventually run out of growth, but they can last for a very long time.

Looking back at the trajectory of these stocks it’s always easy to see why they were successful; but that’s an illusion: because we can’t put ourselves back in the state before we knew they were destined to achieve glorious success we can’t see the issues and the pitfalls that they had to circumvent to achieve success. All we can see is the outcome, not the process.

This problem of hindsight blinds us to the difficult of selecting and holding onto the next wonder stock. If you look around the markets today you’ll see a whole bunch of wannabees with fantastic business models or technology or marketing, some them with amazing profit margins.  Any one of these may soar to glory; but most will fall to the pressure of the invisible hand.


But what’s even worse is that even if you identify a company destined for super stardom the chances are you won’t hold onto it. In the UK we have an online fashion retailer called ASOS which has ridden the rise of e-tailing brilliantly. I must know 50 people who bought this as a penny stock at under 30 cents. ASOS is currently worth about £30 (roughly $40) a share; at times it’s traded at twice that figure.  Not a single one of those investors held on for the ride.

ASOS, like every superstock before it, didn’t have a smooth ride to the top, it stuttered and stammered, took a couple of steps back and occasionally tripped over its own stylish laces.  And it had its own moment of misfortune beyond its control when its only warehouse was damaged by a nearby fuel depot blowing up in the biggest explosion in the UK since World War Two. As you might imagine an online retailer without a warehouse during the critical Christmas trading period wasn’t looking like an especially good investment.

An Explosive Meme

However, ASOS was riding a trend and executed wonderfully well. Anyone buying and holding after the Buncefield explosion would have seen their investment multiply 40 times. But most people didn’t; most people traded away their gains as the share price soared, satisfied or even happy when they’d doubled or tripled their money. 

It’s a great story, the meme of the superstock, and everyone wants to find the next ASOS but the brutal reality is that most ASOS-like stocks suffer from mean reversion. For a company like this to be successful and stay successful they have to establish a niche and then defend it against all comers – and the management have to be madly confident to stick with it. Even the founders of Google tried to flog their company for a million. Really, what were the chances that Google would execute so well that it would dominate online search and figure out how to monetize it? That too only looks inevitable in hindsight.

Fragile Trends

Apart from a handful of super soar away stocks the rest of the market mainly operates on the basis of mean reversion. If a company finds some area it can make excess returns on it attracts competition, which reduces the margins. Occasionally a company finds a way of defending those margins, and is able to produce better than average returns over long periods: we generally call these quality stocks and they generally trade at a premium. But markets are nothing if not psychologically fragile and sometimes quality stocks become available at sale prices; usually investors find some reason not to buy them.

If we can’t identify superstocks even when we’re holding them then operating on the basis that we can identify them at all is plainly stupid. Operating on the basis of mean reversion – that any trend will continue until it stops and that good companies doing sensible things will continue to do sensible things and make above average returns is plainly sensible. Add to that a sensible amount of diversification and you have a recipe for a reasonable return.


Unfortunately most people can’t do this. In fact, most people do exactly the opposite. They chase hot sectors and shares and they spend their lives looking for wonder stocks. When markets turn down or quality stocks fall they sell in order to avoid losses, rather than buying in order to take advantage of mean reversion.

It’s not exactly new knowledge that mean reversion works and that quality stocks tend to keep earning above average returns and should therefore be bought whenever their valuations fall into normal territory. James Poterba and Larry Summers demonstrated this behavior over the the extant twentieth century in 1987 in Mean Reversion in Stock Prices: Evidence and Implications. They also showed short term momentum effects, suggesting that these were down to noise traders chasing returns.

It isn't shockingly revelatory that chasing blue sky stocks in the hope of finding life changing returns is a hopeless task. Nor is it new information that we’re biased towards these behaviors. We all know we suffer from overconfidence and hindsight bias and that we’re risk averse when making money and risk takers when losing it. But the problem is that everyone thinks that this doesn’t apply to themselves, because everyone knows themselves from the insider and everyone knows that they themselves really aren’t biased at all: the so-called blind spot bias.

Talking To Myself

Which is the problem, because if we could tell we were biased we wouldn’t be. It’s the fact that we can’t tell that causes the problems; only people capable of self-calibration can avoid this and there are very few such people born, mostly it’s something investors acquire through painful trial and error, if they ever do so at all.

So, in the main, I’m preaching into the void. The vast majority of people won’t understand what I’m writing about and of the few that do the majority won’t think it applies to them. But that’s not the point, because the only person I really, really need to listen and understand is myself.

And I have high hopes that one day I will.


  1. Not quite preaching into the void Timarr. Those of us that are out here are quietly, slowly absorbing and internalizing the lessons to be learnt.

    The site is a treasure trove with regular flashes of insight around every corner and hidden under every stone.

  2. Your blog e-newsletter updates apparently are now including some Amazon-related widget functionality, which is making my e-mail software app choke. That's kind of rude and inappropriate. As a result, I just unsubscribed from your blog updates. If that was inadvertent, you should fix it and issue an apology. BTW, I'm a student of business models and capitalism, so I get that aspect of the issue. However, you're the only blog/e-mail newsletter I've had this experience with.

    1. Sorry about that, but I have no idea what the problem is. All the email updates are automated and I've changed nothing; and I can't see any problem on the email accounts I use to check everything's working. If you can give a bit more detail about what the problem is then I'd be happy to sort it.

  3. Great post- we all think we are special and we are all looking for that dream stock.
    One comment- you say:
    "It’s not exactly new knowledge that mean reversion works and that quality stocks tend to keep earning above average returns and should therefore be bought whenever their valuations fall into normal territory."

    Here you are actually preaching mean reversion - valuations will increase to historical norms, and a lack of mean reversion- quality companies will keep earning above average returns and not revert to industry norms.

  4. No quite preaching into the void, you know. This has been one of the blogs I read every week as sort of "hairshirt" to make sure I don't get bigger than my britches. You have cured me of thinking myself clever.

  5. "James Poterba and Larry Summers demonstrated ...": heh, heh, that'll be the Larry Summers who proved such a flop when he tried to dabble in money management at Harvard, eh?