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Private Equity

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Steve Kaplan and Antoinette Schoar, "Private Equity Performance: Returns, Persistence, and Capital Flows," MIT Working Paper, November 2003 (278kb). This paper finds that returns on private equity partnerships, net of fees, are about the same as those for the S&P 500.

Reversion to the Mean

Reversion to the mean is the phenomenon (discovered by Charles Darwin's cousin, Sir Francis Galton (1822-1911)) whereby a stock's average performance (or a mutual fund's, or many other non-investing statistics) tend to become more average (i.e., less extreme) over time.  If true, this implies that recent good performers are perhaps somewhat more likely than average to be below average performers in the future (and vice versa).  This idea is supported by much of the research.  Also, see Mutual Fund Persistence.

John C. Bogle, "Bogle on Investment Performance and the Law of Gravity: Reversion to the Mean—Sir Isaac Newton Comes to Wall Street," Speech given at MIT Lincoln Laboratory on January 29 1998. "... RTM is a rule of life in the world of investing—in the relative returns of equity mutual funds, in the relative returns of a whole range of stock market sectors, and, over the long-term, in the absolute returns earned by common stocks as a group."

Bob Bronson, "Reversion-to-the-mean is not a glide path phenomenon," December 14 2000. This commentator notes that mean reversion doesn't mean that an investment's future performance is likely to gradually approach some asymptote.  Rather, it is likely to cycle to the other extreme (i.e., good performance is likely to be followed by bad performance, and vice versa), which over time will cause the average performance to approach some asymptote.

Jennifer Conrad and Gautam Kaul, "Mean Reversion in Short-Horizon Expected Returns," Review of Financial Studies, Vol 2 Number 2 1989, pp. 225-240 (1.52mb).

Werner F.M. De Bondt and Richard Thaler, "Does the Stock Market Overreact?," Journal of Finance, July 1985, pp. 793-805. This paper suggests a behavioral explanation for observed mean reversion: overreaction.  It suggests that "loser stocks" tend to subsequently outperform "winner stocks" because the "loser stocks" became loser stocks to an extent that exceeded rational justification (i.e., they were previously  bid down lower than justified by rational expectations).  Likewise, the "winner stocks" were previously bid up higher than justified by rational expectations.  Over time, those expectations become more rational and the overreactions disappear, causing a reversion to the mean.

Eugene F. Fama and Kenneth R. French, "Permanent and Temporary Components of Stock Prices," Journal of Political Economy, 96 1988, pp. 246-273 (1.8mb).  Also here.  "A slowly mean-reverting component of stock prices tends to induce negative autocorrelation in returns."  "In tests for the 1926-1985 period, large negative autocorrelations for return horizons beyond a year suggest that predictable price variation due to mean reversion accounts for large fractions of 3-5 year return variances.  Predictable variation is estimated to be about 40 percent of 3-5 year return variances for portfolios of small firms.  The percentage falls to about 25 percent for portfolios of large firms."

Eugene F. Fama and Kenneth R. French, "Forecasting Profitability and Earnings," Journal of Business, 73(2) 2000, pp. 161-175. This paper looks at mean reversion of a corporation's earnings.  "Standard economic arguments say that in a competitive environment, profitability is mean reverting.  Our evidence is in line with this prediction."

Jonathan W. Lewellen, "Temporary Movements in Stock Prices," MIT Sloan School Working Paper, May 2001.  Also available here (105kb).  "Mean reversion in stock prices is stronger than commonly believed. ... The reversals are also economically significant. The full-sample evidence suggests that 25% to 40% of annual returns are temporary, reversing within 18 months. The percentage drops to between 20% and 30% after 1945. Mean reversion appears strongest in larger stocks and can take several months to show up in prices."

Burton G. Malkiel, "Models of Stock Market Predictability," Journal of Financial Research, Winter 2004, pp. 445-459 (159kb). This study finds that, while there appears to exist some reversion to the mean behavior, "... there is no evidence of any systematic inefficiency that would enable investors to earn excess returns."  In other words, market timing models aren't likely to be fruitful.

James M. Poterba and Lawrence H. Summers, "Mean Reversion in Stock Prices: Evidence and Implications," Journal of Financial Economics, 22 1988, pp. 27-59. "Our results suggest that stock returns show positive serial correlation over short periods [reflecting a short-term momentum effect] and negative correlation over longer intervals [reflecting a reversion to the mean effect]."

Bill Schultheis, "Reversion in Action," 1999. A great explanation of this concept for lay people.

Tony Weisstein, "Reversion to the Mean."  An excellent brief formal mathematical description of this generic concept.

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