The Bell Curve Can Represent Most Stock’s 10 Week Moving Average

by | Aug 23, 2008 | Asset Management

Recently, oil and commodities dropped 20 to 25% in four very fast weeks, catching nearly everyone off guard. But as fast as the drop took place, we start to see signs of a reversal back up. These sharp violent corrections often take place in long sustained bullish advances.

What do you do if you are still holding commodities like oil, natural gas, heating oil, grains and agriculture? I’d encourage you to read on. If you don’t have a longer-term view, then simply understand this: everything reverts to the mean.

Let me ask you a question…have you ever seen a bell curve?

Here’s an example of a bell curve: suppose there are 20 students in a class.
When test-time rolls around, here were the scores in the class:

1 student scored 100
3 students scored in the 90s
12 students scored between 75 and 85.
3 students scored in the low 70s
1 student scored 60

Roughly 60% of the class scored between 75 and 85.
One student of the 20 (5%) scored extremely well (she got 100%).
One student of the 20 (5%) scored very poorly (she got 60%).

Statistically, there’s a very good chance that the one student who scored extremely well may not get 100% the next time around. Additionally, the one student who scored very poorly stands a good chance of improving her score in the future. This brings these two extreme results back to the middle of the pack.

The reason why I went through this exercise was to show you that frequently results “gravitate toward the mean.” In this case, the mean test score was somewhere between 75 and 85. In fact, 60% of the class fell in that range.

Let’s apply this towards your investments.

Two thirds of the time (67%), investments will hang around the midpoint of the range — the middle of the 10 week moving average.

There will be times when your investment scores in the top 5% — this is a situation where your investment is clearly “over-bought.” There are also times when your investment will score in the bottom 5%. This is when we say your investment is “over-sold.”

The reason why I frequently mention the term “weekly momentum” is because you will see (in a chart) certain times when your investment may get extremely over-bought, or extremely over-sold. This period is usually followed by a time where your investment will revert to the mean.

Knowing these types of patterns and behaviors exist, prevent us from panicking and getting out at the bottom — and likewise, making a rash decision and buying something at the very top. It doesn’t always work perfectly, but we do our best to “stack the odds” in our favor.

Maybe it’s me, but it just seemed like a funny coincidence that as soon as the media started to talk about oil going to $100 per barrel, we saw a bounce (in two days) from $111 a barrel…up to $122 a barrel.