Reversion to the mean; we reference this statistical principal periodically, but what does it really mean? Basically, it refers to the tendency for phenomenon to trend at a certain rate or level. Divergences from this trend are often corrected back to the central tendency or mean (average).
In practical terms, it can point out risk or opportunity. If we consider the stocks in the S&P 500 a surrogate for the economy at large, then the weight of a particular sector tells us something about its importance to the whole. The proportion of any particular sector has a certain weighting as part of the whole. These change over time as the importance of certain industries become more or less important to the whole. Just think of technology compared to 40 years ago. However, sudden changes, up or down, may be corrected back to a longer-term weighting norm.
Late in the past century and early part of this one, the financial sector became popular and heavily weighted in the S&P 500. It had in the past been about 12% to 15% of the S&P 500. Another way of saying that its importance in the overall economy was about this percentage. At peak popularity, the weighting went over 25%. This essentially meant that shuffling money around was worth 1/4 of all economic activity; ridiculous in hindsight. After the financial crash, the weighting of this sector went to under 8%. It has now recovered to 13%. This is an example an over-valued sector coming back into line with historical norm.
These weightings relative to norms can point to risk or opportunity. Today the technology sector is heavily weighted compared to the not too distant past. Energy is dramatically under historical norms. This information is valuable, but not from a timing point of view. Reversions are often triggered by events that come as a surprise to most investors. However, this information can be used to construct portfolios to optimize opportunity versus risk. Talk with Us.