Friday 20 August 2010

Reports of the death of mean reversion are premature

This was originally written for the FT, but they seem to have gone the same way as so much media and are dumbed down these days - they said it was too technical (after sitting on it for more than a week). So I'll post it here in:

In a recent article [1] Richard Clarida and Mohamed El-Erian of PIMCO argued that the ‘New Normal’ offered at least five implications for portfolio management.

I. Investing based on mean reversion will be less compelling

II. Risk on/risk off fluctuations in sentiment will continue

III. Tail hedging becomes more important

IV. Historical benchmarks and correlations will be challenged

V. Less credit will be available to sustain leverage and high valuations

Implications IV and V seem pretty reasonable to me. However, reports of the death of mean reversion are premature. I fear that the authors are confusing the distribution of economic outcomes with the distribution of asset market returns. The distribution of economic outcomes may well turn out to be flatter, with fatter tails than we have previously experienced.

However, asset markets have long suffered such a distribution; it has proved no impediment to mean reversion based strategies. In fact, the fat tails of the asset market have provided the best opportunities for mean reversion strategies. For instance, in equity markets the fat tails associated with unpleasant outcomes (poor returns) have generally occurred as high (sometimes ludicrously high) valuations have returned towards their ‘normal’ level, and the fat tails which we all love (good returns) have occurred as low valuations have moved back towards more ‘normal’ levels.

As long as markets continue to follow the second implication (as they have done since time immemorial) and flip flop between irrational exuberance and the depths of despair, then mean reversion (at least in valuations) is likely to remain the best strategy for long-term investors. (This also highlights the apparently contradictory nature of the first two implications that the authors point out). We don’t require long periods of time at equilibrium for mean reversion strategies to work, rather (and considerably less onerously) we simply require markets to pass through the equilibrium periodically.

As always, investors need to be mindful of the context of their investment decisions. It is always possible that we are standing on the brink of a shift in the level to which asset valuations mean revert. But that has always been the case. Only careful thought and research can work to try to mitigate the dangers posed by this threat. After all, if investing were both simple and easy, everyone would be doing it.

The third implication that tail risk hedging will become more important is and always has been true (much like the second implication). The prudent investor should always pay attention to tail risk – the new normal doesn’t alter that.

Ever eager to please, the ‘engineers of innovation’ (or should that be the ‘architects of destruction’?) are happily creating products to serve the new bull market in tail risk. Deutsche Bank is launching a long equity volatility index, while Citi has come up with a tradeable crisis index (mixing equity and bond vols, swap spreads and structured credit spreads). Strangely enough, Bloomberg reports that PIMCO is planning a fund that will protect investors in the event of a decline greater than 15%. Even the CBOE is planning a new index based on the skew in the S&P 500.

However, any consideration of the purchase of insurance should not be divorced from a discussion of the price of the insurance. Cheap insurance is wonderful, and clearly benefits portfolios in terms of robustness. However, the key word is that the insurance must be cheap (or at very worst fair value). Buying expensive insurance is a waste of time. I used to live in Tokyo and was constantly amazed that the day after an earth tremor the cost of earthquake insurance would soar, as would the demand!

You should really only want insurance when it is cheap, as this is the time when no one else wants it, and (perversely) the events are most likely. Buying expensive insurance is just like buying any other overpriced asset ... a path to the permanent impairment of capital. Rather than wasting money on expensive insurance, holding a larger cash balance makes sense. It preserves your dry powder for times when you want to deploy capital, and limits the downside.

So buy insurance when it's cheap. When it isn't and you are worried about the downside, hold cash. As Buffett said, holding cash is painful, but not as painful as doing something stupid!

In summary, the new normal may pose some issues for investors who have never bothered to study history (which is, of course, littered with many, many ‘new normals’). However, for those with perspective, prudence, patience and process, many of the same ‘eternal’ rules are likely to govern the game as they always have, come rain or shine. In essence, many of the implications are less the new normal, and more the old always!



[1] Uncertainty changing investment landscape, Market Insight, 2 August 2010

38 comments:

Unknown said...

Good post but I did have one question. Do you really believe that an event is more likely to happen because the insurance is expensive? I would think the event insured against is no more or less likely to occur but just that when it is expensive you would avoid it purely because its overpriced.

Also, even if mean reversion strategies will still work in the "new normal". Do you have any concerns that this may be or has become an overcrowded trade?

Unknown said...

Very interesting article. I found your point on hedging tail risk and cheap vs. expensive insurance thought provoking. However how can you tell if the insurance is expensive? Does this mean relative to the historical cost of the insurance?

mdblog said...

Interesting article, but one remark on the price of earth quake insurance in Tokyo: It makes sense for the price to go up after a quake, since it is an event, which is serially correlated. One quake happening raises the probability of subsequent quakes and so prices (for short term insurance) should go up.

Whether this explains all of the increase or whether there is also a psychological components, I don't know.

Unknown said...

III. Tail hedging becomes more important

Particularly when PIMCO has a brand new tail hedging strategy to flog(which will undoubtedly boil down to paying for the backside of the horse that just bolted).

WhiteShadow said...

JUST a matter of time ...mean reversion will not die so easily...like so many ppl say fundamentals are dead cos of HFT. To them and all others no believers of values, and basic market principles....http://boombustblog.com/reggie-middleton/2010/09/07/near-record-high-correlations-is-this-the-end-of-the-fundamental-value-investor/

Unknown said...

I think the increase in market correlations (and asset class for that matter) should actually be benefical for mean reversion. The positions identified as statistical outliers should close easier and more consistently. I've explored this -and other themes here

http://marketsandculture.blogspot.com/2010/11/generating-returns-in-increasingly.html

philarti said...

Thank you for your very true remark about todays media and bearable insight that some art takes a week !

Ross said...

Excellent information, useful and with a great point of view.
Generic Viagra

Unknown said...

Agreed
farmland investing

moonpharmacys said...

Your blog is really excellent. It inspires the readers who have that great desire to lead a better and happier life. Thanks for sharing this information and hope to read more from you. Great information…buy cipro

SteveBrad said...

Simply marvelous!!! Your article provides a fresh new insight to this topic which was yet undiscovered. I must say your research skills are sharp and your narration is interesting. Splendid work…
Buy generic viagra

Unknown said...

Your site is absolutely outstanding. This inspires this visitors who may have of which fantastic prefer to guide an even Buy Wholesale Yacon Root Online better and also more pleased life. Thank you with regard to giving these details and also anticipate to read much more from people. Wonderful information….

Unknown said...

Merely outstanding!!! Your document comes with a fresh new insight to this particular theme that has been still undiscovered. apple ibeacon I need to state your quest knowledge are sharpened as well as your narration is usually exciting. Marvelous work….

Unknown said...

Forte School of Music is providing Music Lessons howick Auckland , New Zealand. Forte School is best in Music , Singing , Guitar and Piano Classes. Contact us now 09 534 2223

Blogger Bangladesh said...

wow, Great Post ever. Knowledgeable article for Me. Your writing skills Very High. I always Loved Your writing. Please keep writing HQ articles.
Please Kindly check My web:

Free YouTube Views
cheapest smm panel
cheapest smm panel
cheapest smm panel
smm panel india
smm panel india
smm panel india

Gs Kumar said...

Thanks for sharing this informative article. Deep information with well written helps a lot.
Motivational Quotes in Hindi

Jack said...

thanks for sharing amazing content.
Lifetime Motivational quotes In hindi
Love Quotes in Hindi For her

Gs Kumar said...

Thanks for sharing.
Good Morning Quotes
Good Morning Images

Faizan ALi said...

Thank you for this lovely post and i read your article and i found this great


Gautam Buddha Quotes in Hindi

Love Shayari in Hindi

Funny Quotes in Hindi

Education Quotes in Hindi

Instagram se paise kaise kamaye

Hindi Motivational Quotes said...

Very simple and easy understandable written.

Love Quotes in Hindi

Awais Ali said...

Your article writing skill is such amazing keep it up the good content. Waqat Shayari

Unknown said...

cowin.gov.in is cowin portal for book vaccine where you can register and, log into the Cowin account using the link cowin.gov.in and also download Cowin vaccine certificate.

Unknown said...

Will will tell you about December global holidays . December is, without a doubt, the most joyful month of the year. This month is filled with various.

Bengali Status Hub said...

Nice and greatly managed post. Thanks for sharing with us.

ভালোবাসার উক্তি

মৃত্যু নিয়ে উক্তি

টাকা নিয়ে উক্তি

সময় নিয়ে উক্তি

অহংকার নিয়ে উক্তি

Unknown said...

Go to Seva Sindhu official link www.sevasindhu.karnataka.gov.in . You can apply for service or Check Your Application Status on seva sindhu portal.

Unknown said...

Every year new types of mehndi design get popularity and trend in the market. we have many new designs for girls to color with...More Info Visit our Website: https://simplemehandidesign.in

Unknown said...

Wow! Thank you so much dear for share this type information. such a nice article.

Motivational Quotes in Hindi For Success Life

Yashwant Sagar said...

thank u bhut hi usefull post

Read More
Read More
Read More
Read More
Read More

Snake Friend said...


Normally I do not learn article on blogs, but I wish to say that this write-up very forced me to try and do so! Your writing taste has been surprised me. Thanks, quite nice post.


1) Happy Birthday Motivational and Inspirational Wishes,Messages & Quotes

2) GOODNIGHT STATUS & QUOTES FOR WHATSAPP

3) Very nice Post

Admin said...

Download the best mod apk in one click. quotes free

free news said...

Download the best status video in one click. drama free

new latest news said...

Fantastic and very help. Thank you for such a great help and guidance. You made something impossible possible. Thank you from the bottom of my heart

Vijay said...

I found thses post very informative...
Paise Kamane Wala Game
Game Khelo Paisa Jeeto App
Paisa Kamane Wala App

Aatif Anjum said...

Atellier Studio is leading 3D Jewelry Rendering service provider. We create high end realistic 3D Jewelry Visualization. Our work has been featured on fashion magazines, jewelry design blogs and online websites such as JTV, Polyvore and Modcloth. 3D rendering is the process of creating a photo-realistic image from a three dimensional computer model of an object or scene in order to get insight into how it would look like before its production. It also helps

BB said...

That was grat! for more info you can visit Best Toaster Oven For Polymer Clay Thanks for you amazing post!

Chetan Herbals said...


Herbal products have been used for centuries to promote weight gain in individuals who struggle with low body weight. Here are some of the best herbal products for weight gain .Ashwagandha ,chitrak ,Bidharikand ,Bidhara etc.

SMM Panel said...

An effective and dependable SMM reseller panel provides a broad variety of social media marketing services to help businesses maximise their online presence and effectively engage with their target audience.

Dark Web Sites said...

I require the majority of the records, Have a preference for seriously favored, We really wish for addiitional information and facts over it, while it is definitely rather great., L8rs used only for documenting.
dark web sites