Regression to the mean is most slavishly followed on the stock market. Wall Street folklore is full of such catch phrases as “Buy low and sell high,” “You never get poor taking a profit.” All are variations on a simple theme: if you bet that today’s normality will extend indefinitely into the future, you will get rich sooner and face a smaller risk of going broke than if you run with the crowd. Yet many investors violate this advice or selling high. Impelled by greed and fear, they run with the crowd instead of thinking of themselves.
Since we never know exactly what is going to happen tomorrow, it is easier to assume that the future will resemble the present than to admit that it may bring some unknown change. A stock that has been going up for a while somehow seems a better buy than a stock that has been heading for the cellar. We assume that a rising price signifies that the company is flourishing and that a falling price signifies that the company is in trouble. Why stick your neck out?
Consider those investors who had the temerity to buy stocks in early 1930, right after the Great Crash, when prices had fallen about 50% from their previous highs. Prices proceeded to fall another 80% before they finally hit bottom in the fall of 1932. Of consider the cautious investors who sold out in early 1955, when the Down Jones Industries had finally regained their old 1929 highs and had tripled over the preceding six years. Just nine years later, prices were double both their 1929 and their 1955 highs. In both cases, the anticipated return to “normal” failed to take place: normal had shifted to a new location.
Peter Bernstein, Against the Gods