This newsletter is not about giving your time and money to charity, although I encourage you to do so; this is about a fundamental concept of statistics called mean reversion that we all need to keep in mind. Basically, mean reversion states that when data points diverge from a long term average, eventually they will "correct" and move rapidly back toward or through the average. In the context of the stock market, it suggests that periods of extreme performance, either up or down, will likely be followed by a correction that will bring the short term averages more in line with the long term averages. If you consider that the S&P 500 has on average returned about 10% annually since 1926, this suggests that periods of time with returns greater than10% will likely be followed by periods with returns of less than 10%, and visa versa. The following chart shows average returns for the S&P 500 for various twenty-five year periods from 1926 through 2001 and the highest and lowest year returns during those periods. You’ll note that while the averages do vary somewhat, they are still remarkably consistent, but the highs and lows over those periods are quite volatile. In each twenty year period, there were extremes of ups and downs that ultimately averaged out to produce near 10% returns.

So what’s the point of all this? Simple, with 2003 returns of 25% for the S&P 500 and 50% for the NASDAQ, it’s fair to assume we will, sooner or later, revert toward the mean. Or, in more plain English, we’ll be giving some of that return back. That’s not to say that we’re going to see a big sell off in the market, but rather this is to remind us that years like 2003 don’t come along every year and over time will likely be offset by years with much lower returns. Expect that you will occasionally give back some of your stellar returns but ultimately do well over time. As I have said before, long term investments in the stock market are as much a bet on the long term growth of the U.S. and world economies as it is on the markets themselves. Above all, avoid trying to time the market, stay invested and remember you are in it for the long haul. By the way, had you sold after any of the period high return years above it would have been unfortunate because every one was followed the next year with a double digit positive return. Mean reversion happens, but like most things related to market returns, it doesn’t happen in a straight line.

As always, please feel free to call if you have any questions.

Randy Gridley

February, 2004