Here’s what I think happens when we look at a stock market chart. Our eyes draw the line from the starting point to the ending point. We notice that the chart goes up and down, but eventually it always comes back to that nice straight line in the middle of all the jagged ups and downs. Our common sense mistakenly calls this "mean reversion", and we think we are seeing something significant, when what we are really seeing is just an average of things, where some of the things are above the average, and some are below, and that is not of much use or significance.
‘Common sense’
When our common sense gets fooled this way, we incorrectly conclude that if the market or a stock goes way down for a long time, it must eventually come back up again and make up for its losses. Similarly, if it goes way up for a long time, it must eventually come back down again. We may even extend the illusion to conclude that we can take advantage of the current patterns and use them to forecast future patterns.
We see this kind of "common sense" every day, where people say things like "I hope the market suffers a major decline, so I can buy at lower prices". The assumption being that it will necessarily result in significantly higher future returns.
These statements usually turn out to be true, but they only become true ex-post. In other words, our common sense fails when it doesn’t remember that all of this is only true after the fact. At any given point in time, investors have no way to see that nice straight line in the middle leading into the future. They can only see the one that leads into the past.
From ‘Mean Reversion, Forecasting and Market Timing’ by John Norstad @ mac.com
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