Mean Reversion and You
The reason I talk so much about setting the odds in my favour is because investors really don't know what's going to happen in the future. There are tendencies -- probabilities shown through experience -- but tendencies aren't certainties. The best an investor can do is to look at the tendencies of the past and, through sound reasoning, assess the current situations based on those tendencies.
One tendency critical to value investing is mean reversion. Mean reversion is just the tendency for outlier cases to revert to a more typical value or occurrence. Take family hight. A man and women who are extremely tall can be expected to have tall children. The tendency, though, is for those children to be somewhat smaller than their parents. Each successive generation will gravitate further towards average human hight. In this way, family hight tends to revert to the mean population hight.
The same is true for investing and investors should see two obvious courses of action. The first is that most money managers who have performed well over a number of years will revert back to the typical returns for money managers as a whole. Picking hot money managers does not add value to your savings, in most cases. The second is that the fortune of most companies revert back to a more typical, or average, level of profitability over time. Because of these two implications of mean reversion, investors should avoid both hot money managers and hot stocks in favour of stocks that have hit a snag causing their price to be depressed relative to standards of value, or to select money managers that have a solid track record of making good investment decisions based on the available information -- typically by picking high potential, low risk, value stocks.
When it comes to investing your own money, investors can look at how specific value stocks have faired as a group over time. The population returns for low PE, low PB, or low price-to-NCAV stocks are just three examples. If we accept that mean reversion is a law of finance then choosing the absolute cheapest stocks relative to value means that those stocks have much further to advance before becoming fairly valued. Not only does this strategy work, but it works exceptionally well.
This is one of the reasons I think that net net stocks work out so well. Since these stocks are trading at the cheapest valuations possible, the stocks have to rise that much further to reach an average level of profitability.