The Second Most Important Concept in Investing!

Today we will try to understand the second most important concept in investing journey.

"The concept of law of averages or Reversal to Mean".

The first and most important concept being the power of compounding. 

Let's start with what we may have heard to give context!

Buy when there is fear,

Sell when there is greed!

--Warren Buffet

Ever imagined why such contradiction in what the legendary investor suggests vis a vis what the majority of people do?

Because in his typical style, warren buffet exclaims that investing is 1% knowledge and 99% common sense. Further common sense is not common.

But why these inverse relationships? Today we will explore what we call the law of averages or in a more statistical manner the concept of Reversal to Mean. 

What does the law of averages or Reversal to mean imply?

Mean reversion, or reversion to the mean, is a theory that suggests that historical returns and asset price volatility eventually return to the long-run mean or averages.

In simple terms, in the longer term, anything which goes up more than average shall come back to average. Similarly, anything which goes down more than average shall converge to average as well. 

Ok - Can You give an example, please? 

Consider an example of legendary player Sachin Tendulkar.

He has played 452 innings in ODI and scored 18426 Runs at an average of 45 approx.

Now we all know he has scored 49 centuries and 96 half-centuries in ODI's However not all innings were a century/half-century. Further, he has been out on 0 (duck) as well, however not all innings were 0. Ultimately he performed near his personal average.

This is the sheer concept of the law of average.

Generally speaking, even the best player playing in the purple patch of their career have their downfall. Also, the worst player playing in the worst form of their life can get up and create wonders.

Over a longer period of time, it all boils down to an average.

Take ourselves for an example, Can we give our absolute best every day? No - there ought to be bad days. However, more often than not, we tend to put in an average effort (average for everybody is different. Therefore personal averages are different.)

However, we all can strive to improve this average. The better this average, the better we are in our personal/professional life.

Does the same concept apply to my investment?

Absolutely!

To give you a context, Sensex has given a return of 12-13% since 1990. While there have been years of significant downfall and significant upside as well, the average return has been around 12-13% CAGR.

Here we need to go back to the buffet analogy.

When the markets are at the top, there is euphoria and a novice touching anything turns to gold. At this point in time, we hear these stories of people leaving jobs for stock markets.

However, the tide turns, and as it turns out the investment at the peak gives a lower return.

Further, when there is a sudden crash, there is panic all around. The same stock which you were willing to buy for 100, you still want to wait for more correction even if it is priced at 60. It is this moment when sanity should prevail and funds deployment should take place.

Because as normal investors, we are net buyers of stocks in our lifetime. And for a buyer, lower prices are beneficial.

Check this table below for 3 Years CAGR Return Since 1990 till 2023 to understand the divergence in returns:

3-Year CAGR Return	% of Times
Less than -20%	0%
0 to -20%	15%
0 to 20%	64%
20 to 50%	20%
Greater than 50%	1%

Source: ICRA 

We have written about the history of bull and bear markets in India here:

https://refreshingfinance.blogspot.com/2023/04/the-pace-of-rise-and-fall-in-stock.html

The end game?

For a normal investor, it is extremely important to understand one Hindi proverb

"Ye wakt bhi beet jayega"

English translation: This time too shall pass.

This is a singular sentence that gives happiness when we are sad. While it saddens us when we are too happy. 

The markets are rational over a longer period of time. However, they tend to display irrationality over a shorter time frame.

Covid will come and go,

Russia-Ukraine war will come and go,

Recession will come and go,

Quantitative Easing will come and go

However, the markets will return to mean and it will deliver an average return. The question is are we willing to stay in the markets through thick and thin? 

The maximum number of investors does not even beat the return earned by indices like Sensex/Nifty leaving aside the concepts like alpha.

So for a normal investor, starting with index investing or a balanced advantage fund can be a good start before maturing into any other complicated products to start earning average returns.

My Personal Investment Journey:

I have been pre-dominantly investing through Mutual Funds for a decade now. This helps me in two ways i.e. discipline and automation in investing.

Over the last decade, my CAGR returns have gone through thick and thin.

In the first year, it was as high as 40%.

In the covid year, it went into negative territory up to 7-8% overall CAGR.

Post-Covid recovery - it increased to above 20% CAGR.

In this sideways market, the portfolio return is around 12% CAGR.

So yes I have seen a few cycles in my investment journey. However, one thing that I have continued and which I recommend is the continuity in the investment journey through SIP.

As a popular saying goes:

"Complexity is the enemy of success." 

In other words, simplicity can be a true friend of success.

DO REMEMBER THE CONCEPT OF THE LAW OF AVERAGES BEFORE YOU TAKE AN ERRATIC DECISION BASED ON IMPULSES IN YOUR INVESTMENT JOURNEY! 

What is your take on the matter? Do let me know your feedback.

You can reach out to me by:

Whatsapp: 8530305060 (https://wa.me/qr/BGBBCGYQJFTUF1)

Email: CAparthshah2811@gmail.com

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The writer is a passionate student of finance and markets.

CA Parth Shah

You can read all my previous blogs here:

http://Refreshingfinance.blogspot.com

Thanks for reading!