COGNITIVE BIAS
When the Extraordinary Returns to Normal
Published date: 3 March 2025 | 5-Min Read
The regression to mean cognitive bias
In VC and PE, making data-driven, rational decisions is essential. However, a subtle cognitive pitfall: Regression to the Mean can lure investors into chasing extraordinary performance, mistakenly believing that such results will continue indefinitely.
This bias leads to a dangerous misinterpretation: what appears to be a breakthrough is often a statistical fluke, destined to revert to normal levels.
The Psychology Behind Regression to the Mean in Investing
Regression to the Mean is rooted in a simple statistical truth: extreme events are usually followed by outcomes closer to the historical average.
In the investing arena, this means that companies or funds experiencing unusually high performance are more likely to see their returns settle back to typical levels.
Investors, dazzled by recent peaks, may overestimate the sustainability of these outlier results, ignoring the natural ebb and flow that history reliably demonstrates.
How Regression to the Mean Skews Investment Allocation
In venture capital and broader investment management, Regression to the Mean can lead to several misallocations:
- Overvalued Outliers (70%)
A substantial portion of capital chases after those companies experiencing explosive, albeit temporary, performance. Investors, captivated by record returns, may pour funds into ventures that are statistically likely to revert to average levels.
- Underappreciated Consistency (15%)
Companies with steady, reliable performance often fly under the radar. Their lack of dramatic spikes can make them appear less attractive, even though they offer consistent, long-term growth.
- Emerging Opportunities Overlooked (10%)
Sectors that haven’t yet had their moment of extreme success might be undervalued, as investors wait for a dramatic signal that never comes.
- Neglected Niches (5%)
Stable, niche markets may be sidelined because they don’t offer the allure of outlier performance, even if they provide robust risk-adjusted returns.
Why Investors Misinterpret Outlier Performance as the Norm
Under conditions of market uncertainty and volatility, the allure of extreme returns is powerful. Investors often cling to recent high performance, mistaking it for a signal of enduring success.
The comfort of an extraordinary narrative, bolstered by media hype and peer validation, can override statistical evidence that simply doesn’t capture the excitement and thrill of those soaring highs.
Strategies to Mitigate Regression to the Mean
While it may seem tempting to chase after yesterday’s record-breakers, the key to long-term success is recognizing that extreme performance is rarely sustainable. By anchoring decisions in long-term data and rigorous analysis, investors can better distinguish between fleeting outliers and genuinely robust opportunities.
1. Don’t Get Carried Away with the Hype
Avoid being swayed solely by headlines celebrating this year’s top performers. Recognize that sensational short-term successes can often be statistical outliers—one-off moments that may not persist over time.
2. Dig Deep into the Fundamentals
Look beyond surface-level performance metrics. Analyze the company’s financial health, business model, and competitive landscape. Strong underlying value is a more reliable indicator of future performance than a brief period of extraordinary results.
3. Separate Luck from Lasting Strength
Ask yourself: Is the impressive performance a result of a fortunate coincidence, or does it stem from sustainable business fundamentals? Compare the current success against historical trends and industry benchmarks to assess its real substance.
4. Focus on Long-Term Trends
Short-term performance spikes often regress to the average. Keep a long-term perspective when evaluating investments and be cautious about overvaluing recent exceptional returns. Consistency over time is a better predictor of future success.
5. Diversify and Manage Risk
Even the best outliers can fall back to the mean. Build a diversified portfolio that balances high performers with steady, reliable investments. This approach helps cushion the impact if an outlier’s performance normalizes, ensuring more stable, risk-adjusted returns.
Final Thoughts: Investing Beyond Outlier Obsession
Regression to the Mean reminds us that the market’s highest highs are often followed by a return to normalcy. While extraordinary results may spark excitement, they should not be mistaken for a new norm.
Embracing the inevitability of mean reversion can help investors avoid the pitfalls of overvaluing momentary successes. A focus on enduring fundamentals, tempered with an appreciation for market cycles, allows one to build a portfolio that thrives over time, grounded in reality rather than chasing ephemeral peaks.
Investors who successfully integrate both quantitative analysis and qualitative insights are better positioned to harness true value.
Sources:
Rolf Dobelli, “The Art of Thinking Clearly” (2013)
Howard Marks, The Most Important Thing: Uncommon Sense for the Thoughtful Investor
James Montier, insights on market cycles and mean reversion
Ben Carlson, A Wealth of Common Sense
About ACE Alternatives
ACE Alternatives (“ACE”) is a tech-driven service provider for Investment Fund Manages in the Alternative Assets space. ACE’s vision is to redefine fund management by demystifying complexities and promoting transparency.
Asset classes include Venture Capital, Private Equity, Private Debt, Fund of Funds, Real Estate, and more. With a proprietary tech platform and extensive industry experience of the team, ACE offers 360 degree tailored solutions for fund administration, tax and accounting, compliance and regulatory, ESG needs. The fintech was founded in Berlin in 2021 and has since established itself as one of the fastest growing alternative investment fund service providers in Europe. ACE is currently working with over 45 funds and steadily growing its customer base.
