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So we saw yesterday that company A has much the same profit in pound terms and earnings per share terms as Company B over a ten year period but stands on a share price of 240p, more than double that of Company B.
A possible explanation is that the market sees the recent greater drop in B’s earnings as a strong signal that from this point B will grow at a significantly slower rate than A.
Alternatively, Mr Market may fail to allow sufficiently for “reversion to the mean” in company earnings changes, and Company B’s share price is a victim of this phenomena.
There are many behavioural studies that show, in many walks of life, that people fail to allow sufficiently for extreme deviations from the mean to move toward more modest deviations from the mean as time goes on.
Some insight into this can be gained by considering the following:
Examination performance
Students take a test. There are 100 true/false questions. Each student answers true or false randomly. Thus the mean result is 50% of the questions are answered correctly. But some students score much higher and some much lower simply because of chance.
Now take the top scoring 10% of the students and give them a second test. They again answer 100 question randomly putting true or false. Again the mean score will be 50%.
Thus these students regressed to the mean of all students who took the original test because of randomness.
The best prediction of these “top 10%” is a score of only 50 out of 100.
If there were no luck (good or bad) involved in answering the questions – purely different levels of skill – then an individual is expected to score the same each time.
In real tests, and in many aspects of life, we see the effects of a combination of the presence of both luck and skill.
With some skill present those scoring above average in the first test would be expected on the whole to score above average in the second test. But the element of luck brings the extreme outcomes toward the mean (on average) as bad luck plays its part in some cases.
Why do tall fathers and mothers not have descendants getting taller and taller?
In the 19th Century Sir Francis Dalton observed that an extreme characteristic in parents was not carried over to the next generation completely – they regress to the mean because of the random element in genetics.
Is your medical skill making someone…….
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