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Chapter 7: Problem 12

Someone suggests that it would be a good investment strategy to buy the five poorest-performing stocks on the New York Stock Exchange and capitalize on regression toward the mean. Comments?

Short Answer

Expert verified
The suggested investment strategy, while theoretically grounded in a statistical concept, is risky and oversimplifies the complexities of the stock market. Simply banking on poor performers to 'regress to the mean' neglects other influential factors that determine stock performance and is therefore not a guaranteed successful strategy.

Step by step solution

01

Understanding the proposed investment strategy

In this strategy, it is proposed to invest in the five poorest-performing stocks on the New York Stock Exchange. The idea is that these stocks will 'regress to the mean' - in other words, if they performed extremely poorly in the recent past, they would be expected to perform closer to the average in the future.
02

Understand the concept of regression toward the mean

Regression toward the mean is a statistical concept that if a variable is extreme on its first measurement, it will likely be closer to the average on its second measurement. This concept is often applied to a wide range of topics, including sports performances, weather patterns, and medical treatments, among others.
03

Evaluate the application of this concept to the stock market

While the concept of regression toward the mean is widely applicable, its use in predicting stock market performance is questionable. Stock performance is influenced by numerous factors - including the company's earnings, economic conditions, investor sentiment, and geopolitical events - and not purely statistical trends. Poorly-performing stocks are often in that position due to substantial problems, and the likelihood of them regressing toward the mean is uncertain.
04

Consideration of other factors

Moreover, the strategy also overlooks other aspects of investing, such as risk tolerance, investment timeframe, and the financial health of the companies behind the stocks. Therefore, purchasing the poorest-performing stocks without thorough analysis might lead to substantial investment risks.

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Most popular questions from this chapter

In studies dating back over 100 years, it's well established that regression toward the mean occurs between the heights of fathers and the heights of their adult sons. Indicate whether the following statements are true or false. (a) Sons of tall fathers will tend to be shorter than their fathers. (b) Sons of short fathers will tend to be taller than the mean for all sons. (c) Every son of a tall father will be shorter than his father. (d) Taken as a group, adult sons are shorter than their fathers. (e) Fathers of tall sons will tend to be taller than their sons. (f) Fathers of short sons will tend to be taller than their sons but shorter than the mean for all fathers.

Assume that \(r^{2}\) equals .50 for the relationship between height and weight for adults. Indicate whether the following statements are true or false. (a) Fifty percent of the variability in heights can be explained by variability in weights. (b) There is a cause-effect relationship between height and weight. (c) The heights of 50 percent of adults can be predicted exactly from their weights. (d) Fifty percent of the variability in weights is predictable from heights.

Assume that an \(r\) of .30 describes the relationship between educational level (highest grade completed) and estimated number of hours spent reading each week. More specifically: \begin{tabular}{|cc|c|} \hline EDUCATIONAL LEVEL (X) & WEEKLY READING TIME (Y) \\ \(\bar{X}=13\) & \(\bar{Y}=8\) \\ \(S S_{x}=25\) & \(S S_{y}=50\) \\ & \(r=.30\) & \\ \hline \end{tabular} (a) Determine the least squares equation for predicting weekly reading time from educational level. (b) Faith's education level is \(15 .\) What is her predicted reading time? (c) Keegan's educational level is \(11 .\) What is his predicted reading time?

In the original study of regression toward the mean, Sir Francis Galton noted a tendency for offspring of both tall and short parents to drift toward the mean height for offspring and referred to this tendency as "regression toward mediocrity." What is wrong with the conclusion that eventually all heights will be close to their mean?

After a group of college students attended a stress-reduction clinic, declines were observed in the anxiety scores of those who, prior to attending the clinic, had scored high on a test for anxiety. (a) Can this decline be attributed to the stress-reduction clinic? Explain your answer. (b) What type of study, if any, would permit valid conclusions about the effect of the stressreduction clinic?
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