An important concept about investing is that the various asset classes have different expected returns. We expect those returns and plan around them.
Of course, it’s rare that an asset class lands exactly on its expected return in any given year. It might happen, but it’s rare. Most years most returns are above or below their expected returns. Over time, those annual returns turn into the average, or mean, long-term expected returns for each type of asset.
A related concept in investing is something called mean reversion.
If you have a few particularly good years in a row in some asset class, above the mean returns for it, we don’t expect a new normal expected return. Rather, we expect that you will likely get some bad years in a row, to come back to that average. Likewise, if something performs less than expected for a few years, we’d expect it to outperform to revert to its mean return.
So, if you expect small cap to outperform large cap, like it has since forever, but it hasn’t for several years, what do you think happens next? Do you think that history has been turned upside down or do you think that small cap will outperform to get back to normal? I’d look for small cap to outperform. The four most dangerous words in investing are “this time it’s different.”
I recently saw an article saying there was risk in the market with everything up this year. Well, all those asset classes were down last year, so it’s exactly what you’d expect to see.
Mean reversion happens. Stocks and bonds, and the different types of them have their expected returns. Over long periods of time, you’re going to get those returns. Over short periods of time, returns are going to be all over the place, but then things will revert to the mean.
So if everything’s great one day, or one year, or for five years, expect things to be not so great after that. If things are terrible for a couple of years, they will get better.
My name is Mike Garry, and my company is Yardley Wealth Management. We are a fiduciary, fee-only financial planning, and wealth management firm in Newtown, Pennsylvania. (That’s in Bucks County). Our law firm is Yardley Estate Planning, LLC and is in the same place. We only do Estate Planning work and I am licensed in Pennsylvania and New Jersey.
If you’d like to talk about this or anything else, please reach out: 267-573-1019, [email protected] or @michaeljgarry
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