Reversion to mean: Law of gravity in financial world

The primary drivers of markets – fear, greed are mean reversion, which largely remains unaltered. Most of the economic and business cycle can be explained by the mean reversion. They go in cycles. Almost all the economic and business variable such as interest rates, profits, equity prices move in a cycle.

The performance of the mutual fund schemes is no exception to this and most of them move in a cycle. Nonetheless, there are cases where we can find some of the funds managed to beat their benchmarks over long periods of time, creating an illusion of superior fund management quality of the fund manager. Nonetheless, it is hardly sustainable and falls below their benchmarks or category returns in future because of an indisputable law of the financial market that is, reversion to the mean. Another problem, especially with the funds that have become large in terms of asset size is that they hardly rise again.

The Indian mutual fund industry, though, technically started in 1960’s it only 25 years when actually it opened up for private players, hence we do have a very short period to analyse this trend. Nevertheless, it is well-studied and documented in developed markets like the US. Their studies show a clear trend.

The table below is taken from the book ‘Common Sense on Mutual Funds,’ by John Bogle. The table clearly shows the deteriorating returns of top-quartile growth and growth and income funds relative to the market return over the consecutive decades, as 99 per cent of those funds reverted toward the mean.

The study clearly shows irrespective of the style of investment followed by a fund, they will follow ‘reversion to mean’. Hence, from next time never ever purchase a fund purely based on its past performance as it will lead you to the wrong direction.