Say that you have a six-sided dice and that you are going to throw it 30 times. The first 10 throws produce five cases in which the number ?1? or ?2? or ?3? turn up (low rolls) and five cases in which the number ?4? or ?5? or ?6? turn up (high rolls). That?s about what you would expect, right? What are the odds that at the end of 30 rolls, you will have seen more low rolls than high rolls?
The odds are 50/50. You might see more low rolls. But there is just as good a chance that you will see more high rolls. It could go either way.
Now say that the first ten throws produce nine low rolls and only one high roll, a 90/10 breakdown. Now what are the odds that, at the end of 30 rolls, you will have seen more low rolls than high rolls?
The odds are very strong that this will be the case. The low rolls possess a 9 to 1 advantage at the time you toss the eleventh roll. And the odds are that about 10 of the final 20 rolls will be low rolls too. So the odds are very strong that you will end up with more than 15 low rolls.
How it plays out
This is how it would work with stock returns too if stock returns played out the way Buy-and-Holders say they play out. It?s not. And I think that understanding why they have never played out that way can make you a far more successful investor than you are today.
Buy-and-Holders believe that stock returns play out in a random walk. If that were so, stock returns would play out in the way dice rolls play out. We would see all sorts of variations in the short term. You might have four or five high-return years in a row or you might have four or five low-return years in a row or you might have a mix of the two.
In the short term, that really is what we see. Short-term stock returns really do play out in a random walk. The academic research available to us today tells us that the Buy-and-Holders absolutely nailed one very important question.
The research also shows that the Buy-and-Holders swung and missed on another very important question.
Say that we see nine high-return years in a decade. If stock returns followed a random walk, the odds would be strong that, for the 30-year time-period starting with those ten years, we would see more than 15 high-return years. The same logic that applied with the 30 dice rolls applies here. The final 20 years should produce roughly 50 percent high-return years. So, if the ten-year starting period consists of nine high-return years, the odds of having at least 15 high-return years in the 30-year period are very good.
That?s not what we see when we look at the historical record. In the long-term, stocks do not follow a random walk. In the long-term, stock prices revert to the mean. We haven?t seen this over just one or two time-periods. We have seen this for the entire 140 years for which we have records. Stock prices ALWAYS revert to the mean. Vanguard Founder John Bogle has gone so far as to say that Reversion to the Mean is an ?Iron Law? of stock investing.
It makes no sense
At least not at first.
If you try to figure it out, eventually you do. And once you figure it out, you know something important about stock investing that few of today?s investors know.
The important question is — What would cause Reversion to the Mean? Why do stocks always do poorly for a good number of years following time-periods in which they have done well for a good number of years? And why do stocks always do well for a good number of years following time-periods in which they have done poorly for a good number of years? What the heck is going on?
The reason why we don?t see a random walk in the long term is that stock prices are heavily influenced by investor illusions. Investor illusions are not random. They play out in a highly predictable pattern. We have seen the same general pattern repeat itself over and over again over the course of U.S. stock market history without a single exception to the patten ever evidencing itself.
Investors both love high prices and fear them. They love them because high prices make them feel richer than they are. They fear them because their common sense tells them that the pretend wealth cannot last. So investors ALWAYS bid stock prices up to crazy high levels over the course of 20 years or so and then bid them down to crazy low levels over the course of the following 15 years or so. Since 2000, we have been in one of the stages of the cycle in which we bid prices down (we have a price crash of 65 percent ahead of us if the pattern that has always applied in the past applies again this time).
This is a big deal for stock returns
Once you understand what drives prices up and down, you know where stock prices are headed in future days. When prices are high, they are headed down over the long term. When prices are low, they are headed up over the long term. You should set your stock allocation accordingly.
Lots of people are skeptical about the idea that long-term returns can be so easily predicted. Skepticism is healthy to a point. But how else can we explain a pattern that has repeated itself over and over for 140 years, with not a single exception showing itself?
If coin flips failed to turn out how logic says they must over and over again, we would all accept that something was up. Coin flips that consistently fail to follow the dictates of logic are fixed.
Long-term stock returns have never yet in 140 years followed the dictates of logic (I don?t endorse Buy-and-Hold strategies but I certainly acknowledge that they are 100 percent logical) There is something going on here that we all need to understand better.
Rob Bennett has explained What?s Wrong (and Right) with Using Historical Stock Data to Predict Returns. His bio is here.?