Mean reversion is a financial term for the assumption that an asset's price will tend to converge to the average price over time.
Using mean reversion as a timing strategy involves both the identification of the trading range for a security and the computation of the average price using quantitative methods. Mean reversion is a phenomenon that can be exhibited in a host of financial time-series data, from price data, earnings data, and book value.
When the current
market price
A price is the (usually not negative) quantity of payment or Financial compensation, compensation given by one Party (law), party to another in return for Good (economics), goods or Service (economics), services. In some situations, the pr ...
is less than the average past price, the security is considered attractive for purchase, with the expectation that the price will rise. When the current market price is above the average past price, the market price is expected to fall. In other words, deviations from the average price are expected to revert to the average. This knowledge serves as the cornerstone of multiple trading strategies.
Stock reporting services commonly offer
moving average
In statistics, a moving average (rolling average or running average) is a calculation to analyze data points by creating a series of averages of different subsets of the full data set. It is also called a moving mean (MM) or rolling mean and is ...
s for periods such as 50 and 100 days. While reporting services provide the averages, identifying the high and low prices for the study period is still necessary.
Mean reversion has the appearance of a more scientific method of choosing stock buy and sell points than charting, because precise numerical values are derived from historical data to identify the buy/sell values, rather than trying to interpret price movements using charts (charting, also known as
technical analysis
In finance, technical analysis is an analysis methodology for analysing and forecasting the direction of prices through the study of past market data, primarily price and volume. Behavioral economics and quantitative analysis use many of the sam ...
) although the RSI indicator and Average True Range (ATR) are nascent attempts to capture such systematic pattern.
Many
asset classes
In finance, an asset class is a group of financial instruments that have similar financial characteristics and behave similarly in the marketplace. We can often break these instruments into those having to do with real assets and those having ...
, even exchange rates, are observed to be mean reverting; however, this process may last for years and thus is not of value to a short-term investor.
Mean reversion should demonstrate a form of symmetry since a stock may be above its historical average approximately as often as below.
A historical mean reversion model will not fully incorporate the actual behavior of a security's price. For example, new information may become available that permanently affects the long-term valuation of an underlying stock. In the case of bankruptcy, it may cease to trade completely and never recover to its former historical average.
In finance, the term "mean reversion" has a slightly different meaning from
"return or regression to the mean" in statistics.
Jeremy Siegel
Jeremy James Siegel (born November 14, 1945) is the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania in Philadelphia, Pennsylvania. Siegel comments extensively on the economy and financial markets. He ...
uses the term "return to the mean" to describe a general principle, a financial
time series
In mathematics, a time series is a series of data points indexed (or listed or graphed) in time order. Most commonly, a time series is a sequence taken at successive equally spaced points in time. Thus it is a sequence of discrete-time data. Exa ...
in which "returns can be very unstable in the short run but very stable in the long run." Quantitatively, it is the
standard deviation
In statistics, the standard deviation is a measure of the amount of variation or dispersion of a set of values. A low standard deviation indicates that the values tend to be close to the mean (also called the expected value) of the set, while ...
of average annual returns that declines faster than the inverse of the holding period, implying that the process is not a
random walk
In mathematics, a random walk is a random process that describes a path that consists of a succession of random steps on some mathematical space.
An elementary example of a random walk is the random walk on the integer number line \mathbb Z ...
, but that periods of lower returns are then followed by compensating periods of higher returns, for example in seasonal businesses.
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See also
* Regression toward the mean
In statistics, regression toward the mean (also called reversion to the mean, and reversion to mediocrity) is the fact that if one sample of a random variable is extreme, the next sampling of the same random variable is likely to be closer to it ...
* Autocorrelation
Autocorrelation, sometimes known as serial correlation in the discrete time case, is the correlation of a signal with a delayed copy of itself as a function of delay. Informally, it is the similarity between observations of a random variable ...
* Convergence trade Convergence trade is a trading strategy consisting of two positions: buying one asset forward—i.e., for delivery in future (going ''long'' the asset)—and selling a similar asset forward (going '' short'' the asset) for a higher price, in the ex ...
* Cointegration
Cointegration is a statistical property of a collection of time series variables. First, all of the series must be integrated of order ''d'' (see Order of integration). Next, if a linear combination of this collection is integrated of order less ...
* Pairs trade
A pairs trade or pair trading is a market neutral trading strategy enabling traders to profit from virtually any market conditions: uptrend, downtrend, or sideways movement. This strategy is categorized as a statistical arbitrage and convergenc ...
* Ornstein–Uhlenbeck process
In mathematics, the Ornstein–Uhlenbeck process is a stochastic process with applications in financial mathematics and the physical sciences. Its original application in physics was as a model for the velocity of a massive Brownian particle ...
* Trend following
Trend following or trend trading is a trading strategy according to which one should buy an asset when its price trend goes up, and sell when its trend goes down, expecting price movements to continue.
There are a number of different techniques, ...
* Gambler's fallacy
References
External links
A Mean-Reversion Theory of Stock-Market CrashesReversion to the Mean, Taken to the Extreme
{{DEFAULTSORT:Mean Reversion (Finance)
Market trends