Those who have invested in the equities markets during the last few years can be forgiven if they liken the experience to a roller coaster ride. The tremendous growth in market values through 1999 and most of 2000 has given way to equally dramatic reversals in value since about the end of September. For many, it has been a gut-wrenching experience to see significant built-up value erode in a few short months. There are many lessons to be learned from this experience.

Those who were lucky enough — or had enough foresight — to take profits along the way and diversify into fixed-income investments (or who were invested in mutual funds whose management took such steps) have escaped at least some of the reduction in value. Many astute mutual fund portfolio managers did exactly that with their balanced and asset allocation funds. These funds will likely outperform the major indices and index funds during this down-turn phase. Reducing risk through asset allocation changes is one of the chief benefits of active investment management.

Investors who have a balance in their portfolio between growth, income, and value investing styles will also weather this storm somewhat better than those whose portfolio consists only of growth stocks or growth-oriented mutual funds. The same will be true for portfolios diversified by economic sector and region versus portfolios that are concentrated or heavily overweighted to particular sectors or countries. The benefits of reducing risk through diversification are most noticeable during downturns in the market.

Another lesson concerns expectations. The phenomenal growth in 1999 and the first part of 2000 became the expectation for many investors, part of the “irrational exuberance” made famous by Alan Greenspan, Chairman of the US Federal Reserve Bank. Now this unending growth expectation has been replaced by unwarranted pessimism among many investors. Just as we should have looked beyond the unsustainable upside, so we must now look beyond the temporary downside. Those who are able to keep their focus on the big picture and the long term will not be drawn off course by the irrational short-term movement in markets. It is ultimately the long-term average returns that are most important to investing success.

“Reversion to the mean” is a term borrowed from statistics that is sometimes used by market analysts. It simply means that the system being studied has a tendency to return to its long-run statistical average. Aberrations on one side will tend to be counterbalanced by aberrations on the other side over time, and the overall statistical average will be maintained.

In the case of equities markets, performance well beyond average will be offset at some point by performance well below average. For example, in the 10 years ending February 28, 2001, the TSE 300 Total Return Index experienced a compound annual rate of return of 11.3%. This is just slightly above its long-run rate of return, despite all the wild swings that have been experienced during this period.

You should remember how it feels when markets fall. If you have experienced extreme discomfort, you may want to alter your portfolio to reduce volatility in the coming decade. However, you should also be comforted if you have a plan for the long term and a well-diversified portfolio that will meet your investment goals with only “average” performance.