Definition
Mean reversion is a financial theory suggesting that asset prices and returns eventually return towards their long-term mean or average level, regardless of fluctuations experienced in the short-term. This concept assumes that an asset’s high and low prices are temporary and that its price will tend to move to the average price over time. It is a commonly used principle in various investing strategies.
Key Takeaways
- Mean reversion is a financial theory that suggests prices and returns eventually move back towards the mean or average. This mean or average can be the historical average of the price or return, or another relevant average such as the growth in the economy or the average return of an industry.
- It is a significant concept in finance, particularly in buying low and selling high. If a stock price deviates significantly from its mean, it’s expected to revert back. Therefore, if it’s significantly higher than the mean, it’s considered overpriced and expected to decrease. Conversely, if it’s significantly lower, it’s considered undervalued and expected to increase.
- Despite its importance, mean reversion should never be used solely for investment decisions. It’s a statistical concept, not a guaranteed phenomenon. Other factors like overall market environment, company fundamentals, and investor sentiment, should also be considered.
Importance
Mean Reversion is an important financial concept based on the assumption that a stock’s price will tend to move to the average price over time. It is used as a prediction and decision-making tool by investors and traders.
The significance of Mean Reversion lies in its potential to identify undervalued or overvalued stocks. If a stock’s current price is significantly higher than its historical average, it could be overvalued, indicating a potential future drop.
Conversely, if it’s much below the average, it might be undervalued, suggesting it may rise in the future. Hence, understanding Mean Reversion can help investors make informed trading decisions, potentially maximizing profits and minimizing losses in their portfolio.
Explanation
Mean reversion is a financial concept that plays a crucial role in the overall planning and decision-making process in the financial world. Its primary purpose is to determine the future movement or probable returns of a particular asset or a whole investment portfolio. It suggests that over time, the price of an asset or the portfolio’s returns will move back towards their average or mean value.
Thus, traders, investors, and portfolio managers use this concept to predict future pricing or return trends, especially in volatile markets. It provides a strategic edge as it allows informed decisions based on probable price corrections or rebounds. The mean reversion theory has its primary applications in investment strategy development and risk management.
Investors tend to incorporate a mean-reverting model in their strategies, especially in their algorithmic trading models, as it gauges the fluctuation of prices from a trend line, indicating potentially undervalued or overvalued conditions. If a price is significantly below the mean, the investor might see this as a buying opportunity, expecting the price to ‘revert’ back to the mean over time. Likewise, if it’s significantly above the mean, it could be a signal to sell.
Furthermore, it helps risk managers to form appropriate risk-adjusted strategies by understanding the probable magnitude of asset price swings under normal and distressed market conditions.
Examples of Mean Reversion
Mean Reversion is an important concept in finance, which suggests that prices and returns will move back towards the mean or average over time. Here are three real-world examples:
Stock Market Corrections: If the stock market index, like the S&P 500, has been significantly higher than its historical average for an extended period, mean reversion suggests that it would eventually fall back to its mean, resulting in a stock market correction or a bear market. For example, the dotcom bubble burst in 2000 was followed by a significant correction as overvalued tech stocks reverted to their mean values.
Commodity Prices: Sometimes, commodities can experience significant price swings due to supply and demand factors. For example, in 2008, oil prices reached a record high of $145/bbl due to supply constraints and increased demand. But over time, these prices reverted towards their long-term average because of increasing supplies and lower demand, reflecting mean reversion.
Interest Rates: Central banks around the world adjust interest rates to manage economic growth. If the interest rates are raised too high for a long period, it may slow down economic growth significantly. To balance this, central banks will lower the rates and they will eventually revert to a long-term average. For example, following the financial crisis in 2008, the Federal Reserve lowered the interest rates to stimulate the economy. Over time, these rates have been gradually increased, indicating a reversion to the mean.
FAQs about Mean Reversion
What is Mean Reversion?
Mean reversion is a financial theory that proposes that asset prices and returns eventually return back to their long-term mean or average. The process involves assuming that the high and low prices are temporary and that prices will tend to go back to the mean over time.
How does Mean Reversion work?
Mean reversion works on the assumption that there is an underlying stable mean to which prices will always try to return. This means there will always be a pull to return to this level. If the current price is higher than the mean, the expected future price is less than the current price and vice versa.
What is the key principle of Mean Reversion?
The key principle of mean reversion is the assumption that there is a stable mean to which prices always revert in the long run. This mean represents the intrinsic value of an asset. It is based upon fundamental factors such as earnings and dividends for stocks, or interest rates for bonds.
How to use Mean Reversion in investing?
Traders who use mean reversion strategies typically look for trends that deviate significantly from the statistical mean and bet that it will revert back. They typically sell when a stock price is above its intrinsic value and buy when it’s below, anticipating a return to its true value.
Related Entrepreneurship Terms
- Reversion Rate
- Variability
- Long-term Average
- Statistical Arbitrage
- Volatility
Sources for More Information
- Investopedia – A comprehensive online resource dedicated to investing and personal finance.
- Morningstar – A financial services firm providing comprehensive data and analysis on a vast number of investment offerings.
- Bloomberg – A major global provider of 24-hour financial news and information.
- Financial Times – One of the world’s leading business news and information organisations.
