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

Post by JPH » Sat Jun 09, 2018 5:18 pm

As I was reviewing Bogle's "Twelve Pillars of Wisdom" in his book Bogle on Mutual Funds published in 1994, I recalled this thread while reading #7, The Powerful Magnetism of the mean.
In the world of investing, the mean is a powerful magnet that pulls financial market returns toward it, causing returns to deteriorate after they exceed historical norms by substantial margins and to improve after they fall short. The mean is also the powerful magnet that pulls the returns achieved by portfolio managers toward it, causing the fund's return to move, over time, ever closer to the average returns achieved by other funds. Regression to the mean (bolding mine) is a manifestation of the immutable law of averages that prevails, sooner or later, in the financial jungle.
In fairness, his thinking may have evolved since 1994. This sounds very fatalistic. Various contributors have commented in previous threads about regression to the mean versus mean reversion. My understanding of regression to the mean is that outlier data points can be extreme due to random measurement error, and upon remeasurement will likely fall closer to the true mean. I don't see how that could explain trends unless the measurement process gradually improves. Mean reversion I'm still trying to better understand.
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Re: John C. Bogle explains his interpretation of RTM (reversion to mean)

Post by dumbmoney » Sun Jun 10, 2018 8:17 am

With regard to active management out- or under-performance, this is best explained by the fact that the reference index doesn't perfectly mirror active managers as a group. So when an index does particularly well, active managers underperform (since any deviation from the index is bad); when the index does poorly, they outperform (since any deviation from the index is good). It's neither skill nor chance, but rather - from a certain point of view - a flaw in the index.
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Re: John C. Bogle explains his interpretation of RTM (reversion to mean)

Post by JPH » Sun Jun 10, 2018 9:31 am

I agree with most of that. But what you are describing sounds like what I'm calling a measurement error phenomenon? The index is supposed to measure the true mean value of the market, but sometimes it can go way off. You say it's neither skill nor chance. I don't think a small random component can be denied. Some source of systematic error must explain most of the deviation. Some of that might be due to manager behavior and some to index tracking error. As you say, when the index runs too high active managers appear to do poorly. Then upon remeasurement at some future time, the index again closely approximates the true mean value of the market. I'm more interested in individual funds and their reversion to the mean. What mean? The true mean value of the market must change continuously. What's the "powerful magnet" or "headwind" that can cause reversion/regression back to the mean following a run? Maybe just people timing the market?
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Re: John C. Bogle explains his interpretation of RTM (reversion to mean)

Post by rbaldini » Sun Jun 10, 2018 9:46 am

In other fields, "reversion to the mean" (RTM) is just an artifact of the result that there is noise or measurement error in populations. There is no "force" pushing back toward the mean; it's a statistical effect.
https://en.wikipedia.org/wiki/Regressio ... d_the_mean

Give a bunch of equally intelligent students some standardized test. They'll all do about the same, but with some variation that is hard to replicate - maybe some woke up later than others, or didn't have a good breakfast, or whatever. Now suppose we give them a similar test tomorrow. Consider the best 10 students. Do we expected them to be in the top 10 again? No - all students are equally intelligent, so we actually expect their performance to be the mean. Temporally, that means we expect to observe a drop in their scores. Similarly, the worst 10 students are expected to increase.

Does RTM require that all are equal? No - just that there is some noise or chance in their performance. Statistically speaking, the student with very highest score probably achieved that for two reason: skill and a bit of luck. (You can show that, probabilistically, it is more likely that luck was in his/her favor than not.) Since the expected return of luck is neutral (0), we expect his/her score to be not quite as high as before - reversion to the mean. Same thing in the opposite direction for the student with the worst score.

The term also shows up in genetics. A very tall man will usually have sons who are shorter than him, even after accounting for the mother's height. Why? Because some of that height is likely to be "lucky" environmental effects, which are not passed down to the next generation.

Presumably the application to stocks goes something like this: stocks that have performed well over some time period are probably due to both inherent value ("skill") and a bit of luck. Luck is not expected to repeat, so on average great stocks will be closer to the mean next time, so have somewhat worse performance. Poor stocks should increase somewhat.

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

Post by rbaldini » Sun Jun 10, 2018 9:51 am

JPH wrote:
Sat Jun 09, 2018 5:18 pm
My understanding of regression to the mean is that outlier data points can be extreme due to random measurement error, and upon remeasurement will likely fall closer to the true mean. I don't see how that could explain trends unless the measurement process gradually improves. Mean reversion I'm still trying to better understand.
It needn't be measurement error. If luck is involved, you get the same phenomenon. I suppose, though, that you can think of it this way: a stock's past performance is only an imperfect measurement of its "true" underlying performance - which is what matters for the future.

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