28th August 2012
‘Think different' was Apple's slogan, and it has shown the value of doing so, yet it might just as easily apply to investors who increasingly need to adapt their ways of thinking in the current climate to escape behavioural biases.
Take the age-old concept of ‘reversion to the mean', for example.
This statistical theory argues that after a long period of strong performance, stocks can't avoid going through a bad period; it seeks to explain the cycles of rising and falling prices that markets experience.
At heart, it says that when you compare a market's short-term results to its long-term historical average, you can guess which direction that market is likely to go in the future. So, for example, after a period of outperformance, stocks are more likely to fall, while after going through a down phase, stocks are more likely to rebound.
But is this correct?
Mark Urquhart, fund manager at asset manager Baillie Gifford, says: "I think there are two deeply flawed assumptions implicit in this – firstly, that there is an average price for a stock over time and, secondly, that the external environment remains the same over time so that any deviation from the average price will always be temporary.
"Indeed, I would argue that the exact opposite is true in the sense that change is a normal state, and that we are currently living through a period in which such change can occur very rapidly with profound effects on equity prices."
So relying on assumptions such as mean reversion is dangerous. As averages are necessarily based on historical prices, they can't take shifting economic fundamentals into account. If an industry is dying, the mean-reversion principle won't revive it, and there are plenty of industries dying a death during economic turmoil and beyond.
Besides, if a particular sector is poised for exceptional growth, then it can easily defy the mean. Take the past decade and companies such as Zynga and Groupon who are making headlines and enticing investors around the world.
Urquhart says: "Both of these businesses are less than ten years old and are potentially hugely disruptive forces in gaming and retailing. They are great examples of why assuming that the past repeats itself can be a very dangerous path to follow."
Whether large, key sector players or minnows, companies are beginning to understand the importance of innovation, alongside marketing. The growth of social media and use of this as a marketing tool is one example of this new world we're experiencing. Today, you have to innovate; to formulate and market your own reputation.
Status quo shattered
Yet despite risk warnings that the past is no guide to the future, many market participants assume that the status quo will persist.
Successful investing needs to harness the reality of rapid change alongside a long-term time horizon, which may post a threat to traditional, blue chip holdings.
Innovation is a key investment theme that Mindful Money keeps returning to. The trouble is, the large companies on which the UK economy is based have proved relatively poor at innovation – so it's the start-ups, and those with a savvy online presence, that are the ones to watch.
As a general rule, however, mean reversion is one of many reasons why maintaining a well-diversified portfolio using various asset allocation strategies makes sense.
By keeping your money in a variety of investments, you'll help balance out the inevitable highs and lows of stock market swings across your portfolio and keep an eye on a profitable horizon.
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