John C. Bogle explains his interpretation of RTM (reversion to mean)

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nisiprius
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John C. Bogle explains his interpretation of RTM (reversion to mean)

Post by nisiprius » Tue May 15, 2018 1:17 pm

I emailed him and asked whether, by "mean reversion," he means active compensation or just failure to persist. He replied. I see that when I asked him for permission to post his reply in the forum, he said "feel free to quote excerpts," so I'll stick to excerpts.

He notes that he discusses this in chapter 9 his book, Clash of the Cultures.
John C. Bogle wrote:"Does reversion to the mean refer to a period of outperformance followed by a period of underperformance, or a period of outperformance followed by a period of average performance?" Ponoma College Professor Gary Smith addressed this distinction head-on in his essay for the Journal of Investing titled, "A Fallacy That Will Not Die." Professor Smith invokes the gambler's fallacy-the false belief that, with respect to a random process, a series of unusual results is likely to be followed by a series of the opposite results.

So, when I talk about RTM, am I invoking the gambler's fallacy? No, I don't think so. Yes, I argue that we often observe periods of outperformance by active mutual funds relative to the S&P 500 followed by periods of underperformance. But, I would argue that this is not a random process like the flip of a coin. Rather, when mutual funds have periods of strong performance (and I make no claim about whether that is due to managerial skill or simply luck), the temptation to aggressively advertise that performance in order to gather more assets and earn higher advisory fees is often too great.

...I'm not invoking the gambler's fallacy. Rather, outperformance by active mutual funds sets off a cascade of events that create strong headwinds for active managers.
The Gary Smith paper he references is "A Fallacy That Will Not Die," Gary Smith, The Journal of Investing Spring 2016, 25 (1) 7-15. A version of that paper appears to be online here.
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Re: John C. Bogle explains his interpretation of RTM (reversion to mean)

Post by JPH » Tue May 15, 2018 1:36 pm

I understand his headwind theory. But what is proposed as the tailwind that propels the managed fund above the S&P500 median?
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Re: John C. Bogle explains his interpretation of RTM (reversion to mean)

Post by RadAudit » Tue May 15, 2018 2:25 pm

JPH wrote:
Tue May 15, 2018 1:36 pm
But what is proposed as the tailwind that propels the managed fund above the S&P500 median?
Don't know. But as a guess, I would think it would be an outsized bet (overweight) on one sector or one stock vs. trying to duplicate the S&P index in an active portfolio.
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Re: John C. Bogle explains his interpretation of RTM (reversion to mean)

Post by columbia » Tue May 15, 2018 8:37 pm

The subtext (of the OP) being that one should be skeptical of assumptions that ex-US equities will mean revert (whatever that supposedly means)?

If so, I agree. No one should assume anything about the future of financial markets.

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Re: John C. Bogle explains his interpretation of RTM (reversion to mean)

Post by LadyGeek » Tue May 15, 2018 9:04 pm

How should the wiki article be updated? See: Mean reversion

The current text:
John C. Bogle regards mean reversion (or RTM, reversion to the mean, as he calls it) as an important factor affecting all investments. In a 2002 presentation entitled The Telltale Chart (with an updated version included in his 2010 book, Don't Count On It!), he states that RTM is widespread and "can help us to understand financial markets and thereby become more successful investors." (He does not explicitly define the term in that presentation, and it is not perfectly whether he regards RTM as an active compensatory process, or a mere failure of persistence).
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Re: John C. Bogle explains his interpretation of RTM (reversion to mean)

Post by nisiprius » Tue May 15, 2018 9:32 pm

It should, and the article should also include material from the Gary Smith paper Bogle referenced... which I'm in the process of reading, and which is very interesting. However, I haven't absorbed either Bogle's remarks or the Gary Smith paper well enough to feel that I'm ready to summarize them.
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Re: John C. Bogle explains his interpretation of RTM (reversion to mean)

Post by baw703916 » Tue May 15, 2018 10:53 pm

This makes sense. In gambling, assuming a non-biased coin/dice/roulette table/etc. each event has no time correlation with past or future events. So if you flip a coin heads 5 times in a row, the expectation value of the next flip remains 50% heads.

But if a certain category of equities has a price appreciation greater than the overall market, then the valuation ratios relative to the rest of the market must necessarily increase (unless profits are also growing faster than everything else). Since higher valuations are about the only thing known to have a negative correlation with future return, it makes sense that return to mean implies a negative bias, not just an independent random probability.
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