Political  Calculations

What does it mean to say that stock prices will "revert to their mean"?

After all, aren't stock prices supposed to be random? And if they are really random, how on earth could they be following any sort of stable trend for any length of time, whose mean trajectory they might periodically revert back to as time goes by?

And yet, if we look at a long enough period of time, say 22+ years, we find that stock prices would appear to follow definite trends for up to years at a time. Even as they seem to bounce about randomly about these trends as they follow them.

S&P 500, 6 December 1991 through 19 May 2014

Now here's where it gets interesting. From this chart, it's really tempting to start drawing lines where you see trends to try to define them. And in fact, there's a whole field within investing and finance that's dedicated to the practice called technical analysis, where its practicioners seek to identify trends as they progress over time to make investment decisions.

Technical analysis, as it's generally practiced, has a critical flaw. When one charts stock price trends over time, the effect is to treat stock prices as if they are a function of time.

Nothing could be further from the truth, and to understand why, just consider how many times in the chart above that you see the S&P 500 with a value of 600 and how many times you see it with a value of 1200. If time were the driving factor for stock prices, we would see stock prices steadily progress ever upward as time marches ever forward.

Political Calculations

Political Calculations is a site that develops, applies and presents both established and cutting edge theory to the topics of investing, business and economics.

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