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For fundamental investors, this quickening pace of disruption is problematic. As the model in Figure 3.2 conceptually demonstrates, innovation has driven the speed of adoption and therefore disruption. In the 1940s, innovation-driven change took on average 28 years, which is the span of four average economic cycles. In the 1990s, innovation change took on average 14 years, or two economic cycles. Today innovation-driven change takes less than seven years to disrupt an industry. Disruption within that time period, the average length of a historical business cycle, opens investors to the higher probability that their cyclical investment will actually be a paradigm shift.

Faster paradigm shifts call into question all mean reversion–based strategies in a way they never were before. This is very evident in deep value-based mean-reversion strategies, but any strategy that has an underlying assumption that we return to a prior status quo in the next economic cycle is under pressure.

Investors for decades have generally been able to rely on which sectors will outperform during different stages of an economic cycle. The difficulty in achieving your expected return revolved around being correct on time horizon, avoiding excess leverage that might bankrupt the company before the next cycle upturn, and managing the position well through market volatility (avoiding behavioral mistakes). These are not simple challenges, and only a minority of managers progressed through these challenges with positive alpha. However, the biggest risk to mean reversion investments and contrarian investments is a paradigm shift. There is no mean reversion if the industry changes.

FIGURE 3.2 Pace of innovation in business cycle terms

As a value manager you live in dread of a paradigm shift—something changes and leaves you high and dry forever.

—Jeremy Grantham, investor

Although Figure 3.3 is overly simplistic, mean reversion is the primary theory for a number of multibillion-dollar investment management firms. Investors may have very complex strategies and mountains of research and data backing up their strategy, but often strategies boil down to a few core investment beliefs, and mean reversion is one of them. This confluence of capital and disruption has had a significant effect on the concept of mean reversion and must be recognized by investors.

To further pressure mean reversion strategies, the economic cycle has been extended longer than ever before (as we surpass ten years), and the cycle of disruption (paradigm shifts) has shortened significantly. This one change alone will hurt many active investment manager returns significantly.

FIGURE 3.3 Economic cycles and mean reversion