EC Mean Reversion Of Equity Returns And Retirement Planning

Do stock returns exhibit long-term mean reversion? That's an economist's way of asking if stocks get safer the longer we hold them.

Long-term mean reversion would act like a spring returning prices back to a trend line when they advance above that trend or fall below it. The strength of this spring is referred to as its "half-life", the time it would take to recover half of a loss or — often conveniently overlooked — how long it would take to lose half of a gain.

A Society of Actuaries report[6] from 2014 states:

"In a survey by Ivo Welch (UCLA and Yale) in 2000, only 36 of 102 surveyed financial economists said that they believed in long-term mean reversion for stock returns (17 had no opinion and 49 did not believe). "

Among those economists who believe mean-reversion exists, a common half-life is believed to be about 17 years. The longer the half-life, the weaker the effect.

This is an important question for investors because, if stock returns do mean-revert in the long run then stocks are a little less volatile on an annualized basis than a random walk would imply.

As retirees, we have to ask some follow-up questions beyond whether stock returns mean-revert. Does mean reversion equate to less risk? If we believe they do mean-revert, what impact would that process have on retirement plans? How would its impact compare to other factors of retirement planning? How should a retiree bet on mean reversion?

Let's look at the big question first. Do stock returns exhibit long-term mean reversion? Despite extensive research for decades, there is no consensus among economists.

Daniel Mayost of the Office of the Superintendent of Financial Institutions Canada wrote a nice review[1] of the seminal research on the topic in which he concludes,

"The claim that equity returns revert to the mean over the long term is not completely unfounded, and cannot be dismissed out of hand. However, there is at least as much evidence to refute this claim as there is to support it, and there is certainly no consensusanswer within the economics profession".

Well said. So, a definite "maybe".

Despite the lack of consensus, many stock traders have developed strategies to attempt to profit from mean reversion of equity returns. Do the strategies work? They probably do, sometimes, if for no other reason than because nearly all strategies will work sometimes.

James Davis, VP of Research at Dimensional, studied the prospects for trading strategies and found that "Evidence of mean reversion is weak, and 780 simulated trading strategies show very limited evidence of reliably positive abnormal returns [profits]."[2]

If we assume that equity returns do mean-revert, how would that impact a retirement plan?

Many have the impression that the mean-reversion "spring" only pushes below-average returns back up toward the underlying average after a market decline. If you read my explanation above carefully, however, you will note that it would also push higher-than-average returns back down toward the average in the future.

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