When selecting
mutual funds,
it's important to look beyond current performance records that may be mildly — or even significantly — different from the fund's long-term history.
Though many mutual funds perform significantly above average over the course of a single year, very few succeed in doing so over longer periods of time. In the very long term, higher performing funds tend to come down and lower performing funds tend to come up — often in direct proportion to fluctuations in the overall market's return. This phenomenon, called reversion to the market mean, is a dominant factor to consider in long-term mutual fund returns.
How should this pattern affect investing decisions? If reversion to the mean applies to all types of investments, from
growth funds
to value funds,
from large-cap funds
to small-cap funds,
then weighting your portfolio too heavily in any one area — with the hope of staying above the curve — is likely to prove fruitless.
An alternative strategy is to invest in funds that represent a broad cross-section of the U.S. stock market. An
index fund,
for example, might provide a more reliable long-term return than a managed fund, since it invests in the market as a whole. The principle of reversion to the mean suggests that an index fund's long-term returns will closely parallel those of the total market, giving investors a chance at earning returns that approach 100% of the market return.
Marc Lackritz
Marc Lackritz discusses how different assets tend to revert to the mean. But the mean depends on the type of asset.
There is a powerful tendency for total returns on financial assets to regress to the mean. The question is, which mean?
Bond returns — short-term, intermediate-term, and long-term alike — tend to regress, not to the historical norm, but to the interest yield prevailing at the time you make your investment
Treasury bill returns tend to take on a life of their own, because their rates are reset so frequently. During the post-World War II period, T-bill returns show some tendency to regress to a real return (the nominal return less the rate of inflation) in the 1% range
Marc Lackritz