Have you ever noticed that once you praise someone, their performance decreases, and when you punish someone, their performance becomes better? You might have observed that once a player performs too well in cricket or any other game, we praise them, but the next match the player isn’t able to perform as well and satisfy our expectation.
We tend to blame the player and think that the praises made him/her overconfident and thus they didn’t perform well.
That may well be one of the reasons, but we fail to realise one thing: regression to the mean.
What is Regression to the Mean?
In layman terms, it means that a less extreme score would follow a more extreme outcome in the next measurement. This usually happens when the correlation between the two measures is not perfect.
In the above example of a cricket player, the performance of the cricket player may have been above average considering his skills. Performance depends on skills as well as luck. Hence, the next match he played led to a less extreme outcome, i.e., a decrease in performance. The correlation between skill and performance is not perfect because of luck.
Daniel Kahneman, a Nobel prize-winning economist, says that his favourite equations are
Great success=A little more talent+A lot of luck
How Does it Affect Investments?
- One needs to realise that one’s success does not purely depend on one’s ability to invest. It is essential to understand that if you are getting a lot of success by investing, it is very likely that you may not perform so well in the future. If it happens to you, you need to realise it is because of regression to the mean and if you enjoy continuous successes you need to be ready that you may even end up losing money or not gain as much in the future.
- You may tend to buy stocks without researching properly about a company when stock prices are rising. You may forget to realise that this may be some extreme outcome, and you need to be careful while analysing the stock. This might lead to disappointment just as in the case of the cricket player.
Regression to the mean says that things return to normal after having an above-average or below-average outcome. One needs to be comfortable with this notion and not get disheartened after failures or mediocre-success. While investing, one needs to be wary of extreme prices and make well-analysed decisions.
Liked this piece? Also read, Loss Aversion Explained!