A Really Smart Way To Score Higher Investment Returns

Financial planning is all about managing risk, and using mean reversion is a brilliant way to navigate your path to the best outcomes over time and not run out of money in retirement. We discuss this topic in depth with Scott Bondurant, founder of Bondurant Investment Advisory, based in Evanston, Ill.

Larry Light: What is the concept of mean reversion, and why is it important in financial planning?

Scott Bondurant: Mean reversion is a critical concept that assumes an asset’s price will eventually converge to its historical average over time. For example, if the stock market’s long-term return is 10% and it experiences a significant drop, mean reversion suggests that future returns will exceed 10% until the market returns to its average level. Conversely, if the market rises significantly, future returns are expected to be lower until it returns to its mean, another term for its “average.”

This concept is vital in financial planning because it challenges the well-known random walk theory, which assumes that asset prices move unpredictably and that past price movements do not indicate future performance. Understanding mean reversion allows us to forecast long-term returns better and manage the risks associated with investing, ultimately leading to more informed and potentially more successful financial planning strategies.

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Light: How does the traditional random walk methodology differ from mean reversion regarding risk assessment?

Bondurant: Random walk is a key component of Modern Portfolio Theory, and it assumes that asset prices have no memory and that future returns are independent of past performance. This approach leads to a static view of risk, where the long-term return expectation remains constant regardless of market fluctuations.

In contrast, mean reversion considers that extreme market movements are often followed by opposite reactions, thereby adjusting the expected returns based on current valuations. Our research has shown that incorporating mean reversion into risk assessments significantly alters the outcomes, particularly regarding the likelihood of running out of money during retirement and the potential growth of assets over time. For instance, portfolios with a high equity allocation show a lower probability of going broke when mean reversion is considered, compared with random walk assessments.

Light: What implications does mean reversion have for investors, particularly those planning for retirement?

Bondurant: Mean reversion has profound implications for retirement planning. Traditional financial advice often recommends a conservative approach as clients near retirement, typically favoring bonds over equities due to perceived lower risk. However, our research suggests that this might be a flawed strategy. By incorporating mean reversion, we find that portfolios with higher equity allocations provide a better chance of preserving wealth and offer significantly higher expected ending assets.

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For example, in a 30-year retirement plan with a 5% withdrawal rate, a 90-10 equity-to-bond portfolio shows a much lower chance of running out of money and higher median ending assets compared to a more conservative 60%-40%, stocks compared with bonds, portfolio. These outcomes suggest that, contrary to popular belief, a higher allocation to equities could be more beneficial for long-term financial security, especially when mean reversion is considered.

Light: Can you elaborate on the potential drawbacks of not incorporating mean reversion in financial models?

Bondurant: Failing to incorporate mean reversion in financial models can lead to overly conservative investment strategies, which may inadvertently increase the risk of running out of money. Traditional models based on the random walk methodology tend to overestimate the risks associated with equities over long periods, leading investors to allocate more to bonds and cash. While this might reduce short-term volatility, it also limits the potential for asset growth, which is crucial for sustaining withdrawals during retirement and leaving a financial legacy.

Moreover, such models do not account for the impact of starting valuations, which can significantly influence future returns. By not considering mean reversion, investors might miss out on opportunities to maximize their wealth, particularly during market downturns when equities are undervalued. They may have to reduce spending or extend their years of work in order to guard against outliving their assets.

Light: What key takeaways should financial advisors and investors consider from your research on mean reversion?

Bondurant: The key takeaway is that mean reversion offers a more nuanced and potentially more accurate approach to financial planning and portfolio management. It challenges the conventional wisdom of random walk theory. It does so by by showing that equities, despite their short-term volatility, tend to revert to their mean, offering lower long-term risk and higher potential returns.

Financial advisors should consider integrating mean reversion into their risk assessments and portfolio recommendations, especially for clients with long-term investment horizons. This approach helps construct portfolios that are better aligned with the goal of not outliving one’s assets and maximizing the potential for wealth accumulation. Ultimately, by embracing mean reversion, investors can make more informed decisions that align with their financial goals and risk tolerance.