Regression to the Mean

Regression to the mean is the tendency of extreme events or outliers to be followed by events or data closer to the mean. Mean is the average of all events or data.

‘Sports Illustrated Jinx’ is an urban legend that states that an athlete whose picture appears on the cover of Sports Illustrated magazine is doomed to perform poorly the following season. Overconfidence and the pressure of meeting high expectations are often offered as explanations. But as Daniel Kahneman explained in his book ‘Thinking, Fast and Slow’, "There is a simpler account of the jinx: an athlete who gets to be on the cover of Sports Illustrated must have performed exceptionally well in the preceding season, probably with the assistance of a nudge from luck, and luck is fickle.”

Often times, when something extreme happens and the extremity recedes in subsequent events, we look for a cause, but what really happens is a simple rule of statistics, and that is regression to the mean. In markets, when assets become overvalued due to whatever reasons, regression to the mean works its magic to pull the prices down and vice versa. In cases like this, we often look for causal explanations because our mind is strongly biased towards them and does not deal well with mere statistics. Regression to the mean holds true because the variables that lead to extreme events or outlier results (e.g. luck, irrational exuberance, unjustified pessimism, economic cycles) are fickle.