We humans are creatures of momentum. We expect things that have gone well to continue to go well and things that have gone poorly to continue to go poorly.
This is true in many ways. One of the easiest places to observe is in the stock markets. Many of us tend to look at stock that has gone up a lot and we expect it to keep going up. We know cases where this is true.
For example, over the five years ending in 2007, Apple was the second-best stock among the members of the S&P 500 with a total shareholder return (TSR) of 2,665 percent. Over the subsequent five years through 2012, Apple was still a great stock, with a TSR in the 95th percentile.
We of course know stocks that were bad year after year, like E*TRADE. During the raging five-year bull market through 2007, E*TRADE managed a TSR of -27 percent, which was worse than 98% of the S&P 500. Their encore over the next five years through 2012 was a TSR of -75 percent, which was worse than 99 percent of the S&P 500.
TSR captures the total return realized through changes in the share price plus dividends over a period. These benchmarks are against the current members of the S&P 500, of which 441 of them have data for the full period.
If you invested $1,000 in Apple at the start of this 10-year run it would have been worth almost $75,000 and a similar investment in E*TRADE would be worth $184. The difference is staggering and these spectacular successes and failures tend to attract our attention.
The only problem is Apple and E*TRADE are anomalies and the reality for most stocks and the companies they represent is quite different.
We studied the TSR of all current members of the S&P 500 during the five years through 2007 and the following five years through 2012. How strong or weak a stock is in the first five year period tells us practically nothing about the next five years.
The strong-performing stocks during the first period were pretty well distributed across the top, middle and bottom performers over the next five years. It was the same for the bottom performers during the first period. If anything, there was a slight bias toward the top companies being a bit below average the next five years, and vice versa, but this varies a bit if you examine prior data through 2011 or 2010.
The formal name for the phenomena is reversion to the mean. We see it in financial advertisements that show exciting historical performance and then tell us past performance is no guarantee of future returns.
Most of us are not professional stock pickers, so this reversion to the mean may seem of little relevance. But for CFOs and other senior executives there are two important implications for strategy development and goal setting.