Will your investments continue to grow lifelong?

Imagine that returns on your investments are continuously rising and majority of the analysts predict a strong uptrend for your securities. You would be elated that your investments would surely give voluminous returns in the months to come. However, just assume if a proportion of analysts say otherwise? Wouldn`t it have a pinching effect. ``Mean to reversion`` theory exactly means the same.

Investopedia defines mean reversion as follows, ``The mean to reversion strategy is based on the mathematical premise that all prices will eventually move back towards the mean or average return.``

Thus, if a stock is underperforming, its price will move towards its average value when the market rebounds. How does this work in case of gold - the safe heaven of many and India`s benchmark index, the 30-share index - BSE Sensex? On comparing average yields of Sensex v/s that of gold from 1980 to 2010, we observed that the index gave a return (min avg yield) of 19% while yellow metal provided returns of merely 2%.  However, while the index has touched a whopping 17K plus in 2010, the prices of gold have touched closed to USD 1250 an ounce. Will the prices continue to rise?

Let`s test the ``Mean to reversion`` theory and find out. To study the theory, we took smaller bracket years from 1995-2010 (15 yrs), 2000-2010 (10 yrs) and 2005-2010 (5 yrs). We observed that in each of the years, the yellow metal had provided absolute returns of 306.59% (while its average annualized yield is 15% p.a.); 306.59% (while its average annualized yield is 15% p.a); and 62.95% (while the average annualized yield was 21 %.). The average (mean) of the returns (yield) turns out to be 12.25%. Now if reversion to mean theory is applicable, the gold prices which have been steadily rising since 2002 is likely to witness a down trend and come back to its mean return of 12.25%.  Let`s see if the same is applicable in our index - BSE Sensex. We studied the prices of Sensex during the same years. From 1995-2010 the Sensex gave an average annualized yield of 12%. Meanwhile from 2000-2010 and 2005-2010 the yield was at 15% and 12% respectively. The average of the three turns out to be 13%.  This shows that after a rising uptrend in the returns of 15% the index gave returns of 12% which was less than its average returns of 13%

How about a public provident fund? In the case of this government security, returns come out at 12% in 1995, 11% in 2000, 11% in 2005 and 8% returns in 2010. The average returns would be 10.50%. Meaning, in the last 15 yrs, PPF has given average returns of 10.50% and more likely that the returns will increase over the years.

The above analysis shows that as there is an uptrend in the returns of the investments over a period of time, the prices return to the average price. With the help of the theory, one can predict the timing in the stock market. Like if we know the average annualized returns of the investments we know at what rate the price will go down near the mean if it is falling or go up near mean if it is in a declining trend. If recent returns have been below average, we can forecast above average future returns, and change our portfolio to allocate a higher portion to stocks.
The drawback!
What we studied, was the historical returns of the prices of investments going back to 1995 and we had the data already available with us, an in sample test which helps to time the market. However, if we go back to the period and take the information only available to us during that time, it would be practically difficult to time the market.