Gambler’s Fallacy And Mean Reversion

Gambler’s Fallacy and Mean Reversion are concepts that remind us that just because something has gone in one direction in the past (up or down), it doesn’t guarantee that it will continue in that direction. As we have seen with technology, real estate, and now commodities and international exposure, things do normalize over time.

As pertains to oil, the solution to high prices is higher prices. We are seeing global demand coming down and alternative resources being brought to the market as soon as possible. At this juncture, there is much more downside than upside in commodities as we see worldwide growth slow. This is simply supply and demand in action.

We need to remember that the market will recover before the economy does - usually 3-6 months beforehand. The market is currently looking at the economy in the fourth quarter of this year and the first quarter of next year.

If the basic idea is to buy low and sell high, that opportunity exists right now! If you wait for the bad news to go away, it’s too late. As a reminder, below are some events in the recent past that the market has overcome and still marched forward:

• 1995 – Dollar at historic lows
• 1997 – Collapse of Asian Markets
• 1998 – Long Term Capital Collapses
• 2000 – Dot Com Stock plummet
• 2001 – Terrorists Attack WTC
• 2002 – Corporate Scandals and Enron
• 2003 – Invasion of Iraq
• 2005 – Trade Deficit
• 2007 – Credit Crunch and Housing Bubble Bursts

An investor with a longer-time horizon should be taking advantage of assets moving away from commodities, real estate, and bonds and into significantly undervalued domestic equities. Mean reversion will occur to the downside, as we have seen in China and India, and we will see with commodities. At the same time, we will experience mean reversion to the upside in the domestic equity markets. The market has brought us to a point where we were almost two years ago, while at the same time ignoring the rate of earnings growth during this period that’s creating attractive values in the market right now.

Presuming Benjamin Graham is relevant anymore, I would consider below his sage advice:

“Mr. Market is your business partner; you and he own equal shares in a private enterprise. Every day, without fail, Mr. Market offers to buy your interest in the business, or sell you his, at a certain price. The problem is, his quotes are all over the place, for Mr. Market is emotionally unstable. Some days he is cheerful and optimistic, and offers an unreasonably high price for your share of the business. At other times, he is gloomy and depressed, and quotes a very low price. But even if you ignore his offer today, Mr. Market doesn’t give up. He will be back again tomorrow with a new one.”

Take advantage of the emotional instability of Mr. Market rather than letting him take advantage of you!

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Comment by Ashley

2008-07-15 18:17:11

I prefer to sit on cash for a while more

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