The Valley of Mean Reversion
Visualizing how we get pulled back to beta.
Reversion to the mean is a powerful force, but it can be tough to imagine.
While talking with Jason Cohen about his excellent post on predicting the future, I came up with a little visualization.
Instead of looking at a normal curve and seeing average as the top of the mountain, let’s flip the curve and look at it as the bottom of the valley.1
Average is like a strange attractor. It pulls other states toward it. How strongly it pulls is based off how few values are around it. The less values, the harder it is to stay there.
To use Jason’s example, Tesla achieved a CAGR of 55% from 2015 to 2022 (👏). If the mean CAGR for a company their size is 5-10%, they’re going to be strongly pulled back toward that mean.
You Only Beat Average with an Edge
The most useful part of this visualization for me is how hard it feels to climb out of the Valley of the Mean. I need an edge to get me out of there. Whether it’s pure energy (e.g. a willingness to work harder) or some kind of leverage x energy (work as hard as average but do something smarter), it’s a reminder that I need something to get above average results.
But hey, glass half-full is, I need something to get me below average results too.
I use a parabola rather than an actual normal curve flipped upside down because it captures the idea of gravity better. If you use an inverted normal curve you get the wrong idea that if you get to extreme values, you’re so far past the mean that the strange attractor doesn’t pull you in anymore. Or who knows, maybe that’s true 🤷♂️.