The IPL Season was on in full-swing. Suresh & Ramesh thought of playing the IPL Fantasy League to win some great prizes. They both sit on their laptops to form their teams. When Suresh sees Ramesh’s team, he asks him about the composition of his team. Ramesh tells Suresh that he’s picked only the Top batsmen and bowlers of the last season!
Is Ramesh right in thinking extra-ordinary performance of the last season is sustainable every season? If he thinks so, he is probably not aware about the concept of Regression to Mean.
From natural phenomena to patterns in nature…from financial markets to business and economic cycles, all of these experience fluctuations. The growth or de-growth patterns may have a daily/monthly/yearly average. Now many-a-times, values fluctuate and go quite farther from the mean(average) values, on the downside and upside. These extremities do get corrected over longer time frames and will eventually follow the ‘average run-rate’.
However, many-a-times, decisions are taken basis extreme values or outlier values, which will impact estimates and decision making. We should always take extreme values with a pinch of salt and work around long-term average values to begin with.
From the perspective of Investing and Financial markets, here are a few suggestions:
1). Ignore short-term performance streaks and promotions around the same.
2). Ignore catchy & sensational headlines highlighting extremities eg. ‘Best ever this’, ‘Worst ever that’!
3). Invest for the long-term…a truly long term horizon of atleast 7-10 years in Equity markets. Be inert and ignorant about wild fluctuations in the short to medium term. Focus on long term averages and take advantages of extremities on either side.
Thus, focus on long-term averages and patterns and don’t base decisions on extreme data points seen in the interim. It wouldn’t be wise to take decisions basis extremities!
Lets watch this video where Rolf Dobelli explains us more about Regression to Mean and how not to be a victim of the same.
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