Mean reversion is the tendency for asset returns to drift back toward their long-term historical average over time. After periods of unusually high returns, below-average returns become more likely — and vice versa. This makes retirement timing after a long bull market particularly risky.
Mean reversion is the statistical tendency for investment returns to gravitate back toward their long-run average over time. When markets have delivered above-average returns for an extended period, the theory suggests that future returns will likely be lower to bring the long-term average back in line — and the reverse after prolonged underperformance.
How It Works
Mean reversion operates at different levels:
- Valuation-driven: When price-to-earnings ratios are historically high, future returns tend to be lower. This is the most robust form of mean reversion.
- Return-driven: Periods of above-average returns tend to be followed by below-average periods over 7–15 year horizons.
- Short-term momentum: Over months to a year, markets often show momentum (trend continuation) rather than reversion. Mean reversion is primarily a long-term phenomenon.
Key evidence:
| Metric | Below Historical Avg | Near Historical Avg | Above Historical Avg |
|---|---|---|---|
| S&P 500 CAPE Ratio | Under 15 | 15–25 | Over 25 |
| Next 10-Year Avg Return | ~10–12% | ~7–9% | ~3–5% |
The Shiller CAPE ratio (cyclically adjusted price-to-earnings) has historically been one of the strongest predictors of subsequent 10-year returns — not because it times the market, but because it captures how far valuations have drifted from their mean.
Why It Matters for Retirement Planning
Mean reversion has direct implications for retirement timing:
- Retiring after a bull market (high CAPE): Expected returns for the next decade are likely below historical averages. Combined with sequence-of-returns risk, this is the most dangerous time to begin withdrawals at aggressive rates.
- Retiring after a bear market (low CAPE): Expected returns are likely above average, providing a tailwind for the critical early retirement years.
This doesn't mean you should time retirement to markets — but it does mean:
- Use conservative return assumptions when entering retirement after extended bull markets
- Build spending flexibility through dynamic spending strategies that can adapt to below-average returns
- Don't extrapolate recent performance — a decade of 12% annual returns does not mean the next decade will deliver the same
A Practical Example
A retiree retiring in late 2021 after a decade of strong equity returns (S&P 500 averaged ~14% annually from 2012–2021, well above the historical ~10%):
- Naive assumption: Continue assuming 10% stock returns based on long-term history
- Mean-reversion-aware assumption: Use 6–7% for the next decade, acknowledging elevated valuations
- Impact on planning: With $1,000,000 and a 4% withdrawal rate, the naive assumption shows a 93% success rate over 30 years. The conservative assumption drops it to ~82%. This retiree might choose to start with 3.5% withdrawals or use a Guyton-Klinger approach with built-in spending cuts.
Frequently Asked Questions
- Does mean reversion mean the stock market always recovers?
- Historically, major stock markets have always recovered from downturns — but recovery can take years or even decades. Japan's Nikkei index peaked in 1989 and didn't recover for over 30 years. Mean reversion is a tendency, not a guarantee, and the timeline is unpredictable.
- How does mean reversion affect retirement timing?
- Retiring after a prolonged bull market means current valuations may be above long-term averages, increasing the probability of below-average returns in the near future. This is sequence-of-returns risk in disguise — the first years of retirement are the most critical, and mean reversion suggests those returns may disappoint after extended bull markets.
- Should I try to time my retirement based on mean reversion?
- Market timing is notoriously unreliable even for professionals. Instead, use mean reversion as a reason to stress-test your plan with conservative return assumptions, maintain spending flexibility, and avoid assuming that recent strong returns will continue indefinitely.