Part 1: Mean Reversion: Why Markets Don’t Stay Extreme Forever

At a Glance:

• Mean reversion is the tendency of asset classes to move back toward their long-term average returns after extended periods of strong or weak performance.
• When markets correct, they often overshoot, much like a pendulum, amplifying volatility and testing investor behaviour.
• Historical data across public equities, private markets, real estate, infrastructure, and bonds shows a consistent pattern:
• Periods of exceptional performance are often followed by muted or negative returns.
• Periods of poor performance tend to create conditions for strong recoveries.

For decades, landing on the cover of Sports Illustrated has marked a turning point for many athletes. Not because of superstition, but because the history is hard to ignore. An internal review of more than 2,400 Sports Illustrated covers found that many featured athletes experienced a noticeable decline in their performance shortly after.

The reason is simple: Athletes earn that spotlight because they are performing at exceptional levels. But extremes rarely last. When performance stretches well beyond what is deemed typical, the forces that created those highs tend to fade, and results often drift back toward more familiar territory.

Markets are no different. Periods of unusually strong returns often cluster near peaks, just as periods of weak performance tend to appear near troughs. Over time, returns have historically tended to move back toward their long-term average. This dynamic is known as mean reversion. It does not predict what will happen next, but it helps explain why markets do not remain at extremes indefinitely. What’s happening in both cases is the same underlying pattern. To understand it more clearly, it helps to start with what we mean by “mean reversion.”

What Do We Mean by Mean Reversion

If you look up the definition of the word mean, you will find several possibilities. It could represent a lack of understanding, as in “I don’t know what you mean,” or convey a level of importance, such as “this means a lot to me”.

In the case of mean reversion, the definition is a mathematical one. “Mean” refers to the average of a series of data points, and “mean reversion” refers to the tendency of asset classes to revert to that mean or average after extended periods of overperformance or underperformance. For the purposes of this discussion, let’s assume five-year periods of over- or under-achievement.

How does this apply to mean reversion? When asset classes correct from new highs and lows, they do not simply return to their average. Much like a pendulum, they are prone to overcompensating on the way back.

This, in turn, tends to exacerbate negative human behaviour, leading to underperformance.

Why Mean Reversion Deserves Attention

We are used to seeing volatility in public markets, particularly in stocks. But it exists in all asset classes to varying degrees. In some cases, the difference in annual returns between one five-year period and the next can reach as high as 30. That is not a typo.

The purpose of this article is twofold. First, to provide a perspective on how mean reversion can impact returns, volatility, and behaviour.

Second, to review our asset allocation model, which we refer to as Core, and show how it is designed to outperform over medium- to long-term periods with much less sensitivity to mean reversion than traditional models. While the theory behind Core is the same as that used by Canada’s largest pension plans, which are considered world-class asset managers known as the Maple 8, it will underperform a traditional 60/40 portfolio from time to time, as it has over for the last two years.

We believe that over reasonable time frames, Core will outperform public balanced models as public asset classes mean revert from their very lofty positions.

Our objective is to help ensure that the journey to achieve and maintain wealth and financial independence does not feel like travelling the road below.

Understanding the Framework

Mean reversion matters because it affects how portfolios behave and how investors experience risk over time. It can make strong periods feel safer than they are, and difficult periods feel more permanent than they tend to be. For investors, the challenge is not identifying when mean reversion will occur, but recognizing how exposure, concentration, and behaviour influence outcomes when it does.

In Part 2, Mean Reversion in the Data: What Markets Have Repeatedly Shown we move from theory to evidence, examining how returns have historically behaved across asset classes following periods of unusually strong or weak performance. The patterns are often surprising, and highly relevant to the environment investors are navigating today.

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