In the previous lesson, I promised to provide three reasons to use the median (which improves with diversification) instead of the mean (which does not). I’ll start with my weakest argument, although it is one shared by many academics in the field of finance:
Equity returns revert toward long-run averages.
The book that first popularized Modern Portfolio Theory was Burton Malkiel’s classic, A Random Walk Down Wall Street. In the first edition, published in 1973, Malkiel made the strong assertion that neither fundamental analysis of a business nor technical analysis of price movements would produce superior returns, and that the future behavior of markets was unpredictable from past behavior. After convincing most of the academic world of this, he then went on to modify his own position in subsequent editions of the book. (It’s currently in its 10th edition.) He has, for quite a long time, admitted that there is some evidence of market behavior inconsistent with a complete random walk. The strongest evidence, in his view (and mine), based on the work of several other researchers as well as his own careful examination and confirmed repeatedly in academic studies of both the U.S. and foreign markets, is that returns above long-term historical averages over a period of a few years (between three and five, depending on the study) are less likely than usual to be followed with similar or better returns in the following few years, and that below-average returns over a few years are substantially less likely than usual to be followed by similar or worse returns over the next few. While the studies vary as to how strong they find the effect, it is rare to find an academic paper on the topic which contradicts this finding.
The much-better average performance of the coin flip than the normal results I cited depends enormously on the extremely positive result that comes from winning all four rounds. (That single $1,600 round in the example from the previous lesson contributed nearly half the $3,906.25 total wealth that resulted from playing the game 16 times.) For an investor with a time frame over five years, though, the effect of reversion will be to reduce the likelihood of that type of result (as well as its horrible opposite, of course). The good news is that stock-market investing appears to be less risky for anyone with an investment time frame of more than five years than the short-term volatility of stocks would imply, and SUBSTANTIALLY less risky for someone with a time frame of 10 or more years. The bad news is that the real-life investment version of the coin-flipping game with the 25% per-round average expected return is not going to provide an average return of 25% per round to the player, even if the experiment can be repeated thousands of times.
OK, that’s a somewhat involved and controversial argument for my position. That one didn’t even convince me. I promise argument number two will be more persuasive.