On CNBC this morning, terms like “oversold” and “irrational pessimism” were uttered frequently. Countless charts and graphs showing stock prices and current yields were abundant (some of them were amazing!). Comparisons of corporate profits now and corporate profits in 2003 (generally, they are MUCH higher now) frequently appeared on the screen. The stock market is at the same value now as it was then. The traders on the floor, at one point, were cheering so loudly as the market came off their lows, that the announcers had to stop talking.
All of this got me thinking about a math term from my Georgia Tech days.
Reversion to the mean:
“Reversion to the mean, also called regression to the mean, is the statistical phenomenon stating that the greater the deviation of a random variable from its mean, the greater the probability that the next measured variable will deviate less far. In other words, an extreme event is likely to be followed by a less extreme event.”
In plain English: when things get out of whack, they tend to get back in line. Don’t know when, but it tends to happen.
I must point out that people often look to reversion to the mean when in a casino. For the most part, each roll of the dice, spin of the wheel, or pull of the slot machine is completely unrelated. For example, just because “black” has come up on a roulette table several times in a row it does NOT mean that “red” is any more likely to appear. This is a classic flaw in the mindset of the casual gambler.