When Results Look Too Good to Be True
When a company posts extraordinary results, investors often celebrate. But before getting too excited, it’s worth asking: Is this sustainable?
That’s where the concept of regression to the mean comes in. It helps us see whether a company’s performance reflects true long-term strength — or just a temporary spike driven by luck or timing.
What Regression to the Mean Means
Regression to the mean is a statistical concept that says extreme results tend to move closer to the average over time.
This happens because chance and randomness play a role in every outcome. When luck helps produce exceptional performance, that effect usually fades in later results. The same goes for poor outcomes — they often bounce back toward normal.
In simpler terms:
“What goes up unusually high often comes down closer to earth.”
Source: Simplified from a Google definition
Daniel Kahneman’s Example
In Thinking, Fast and Slow, Daniel Kahneman shared an insightful story from his time with the Israeli Air Force.
Instructors believed that criticism improved performance while praise made it worse. Pilots who were scolded after mistakes usually did better the next time, and those praised for excellence often did worse.
But Kahneman realized this wasn’t about feedback — it was about regression to the mean.
“When performance is extreme on the first try, it will tend to be closer to average on the next. This is true whether you praise or criticize — it’s a statistical fact, not a psychological effect.”
The Investor’s Trap
Investors make the same mistake.
When a stock performs brilliantly, we credit management or innovation. When it stumbles, we blame leadership.
But often, both reactions are wrong. Markets simply revert to normal after periods of unusual success or struggle.
As Kahneman wrote:
“The illusion that we understand the past fosters overconfidence in our ability to predict the future.”
This illusion drives investors to chase past winners or dump temporary losers — the very behavior regression to the mean warns against.
What It Means for Investors
Regression to the mean offers both a warning and an opportunity:
- Don’t chase recent winners. Exceptional returns often attract overconfidence and overvaluation. Even great companies can disappoint when expectations are too high.
- Don’t abandon temporary losers. Underperformance is often cyclical. As short-term pressures fade, value can resurface.
- Focus on intrinsic value. Markets overreact in both directions, but price and value eventually align.
- Stay humble. Accept the role of luck. It keeps you rational when others overestimate skill or panic over randomness.
Regression to the mean isn’t about predicting when things will change — it’s about understanding that they will.
Final Thought
Markets move in cycles. Performance swings between euphoria and disappointment, but rarely stays at the extremes.
Regression to the mean reminds investors that success isn’t permanent, failure isn’t final, and luck always evens out over time.
For the patient investor, this isn’t a warning — it’s an advantage.
It teaches humility in good times, courage in bad times, and confidence in the steady rhythm that brings everything, eventually, back to its mean.
Happy Investing!
SavvyGrowthPaths 