Mean reversion

Mean reversion is a mathematical concept sometimes used for stock investing, but it can be applied to other assets. In general terms, the essence of the concept is the assumption that both a stock's high and low prices are temporary and that a stock's price will tend to move to the average price over time.^[1]

Mean reversion involves first identifying the trading range for a stock, and then computing the average price using analytical techniques as it relates to assets, earnings, etc.

When the current market price is less than the average price, the stock is considered attractive for purchase, with the expectation that the price will rise. When the current market price is above the average price, the market price is expected to fall. In other words, deviations from the average price are expected to revert to the average.

The standard deviation of the most recent prices (e.g., the last 20) is often used as a buy or sell indicator.

Stock reporting services commonly offer moving averages 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).

Some asset classes, such as exchange rates, are observed to be mean reverting; however, this process may last for years and thus is not of value to an investor.^[2]

Mean reverting should demonstrate a form of symmetry since a stock may be above its historical average approximately as often as below, as predicted by the efficient-market hypothesis. However, saying that a stock is 'overpriced' is a rare statement, since mean reversion is a useful tool for those who wish to sell you stocks. Information asymmetry can make a temporary high or low permanent when the information becomes public.

A mean reversion process that possesses full mathematical validity will not fully incorporate the actual behavior of equity prices. An equity price is a composite phenomenon that is partly mathematical and partly legal: it is a reflection of the legal status of a company. Firms can file for bankruptcy and cease to trade. A mean reversion process will not take into account the observed and common phenomenon that a stock price may hit zero and stay there.

See also

• Convergence trade
• Gambler's fallacy
• Pairs trade
• Ornstein–Uhlenbeck process

References

1. ^ Mean reversion
2. ^ http://www.google.com/search?q=%22mean+reversion%22+exchange+rate&ie=utf-8&oe=utf-8&aq=t&rls=org.mozilla:en-GB:official&client=firefox-a

External links

• A Mean-Reversion Theory of Stock-Market Crashes
• Mean Reversion in Stock Prices: Evidence from Emerging Markets
• Mean Reversion of Size-Sorted Portfolios and Parametric Contrarian Strategies
• Reversion to the Mean, Taken to the Extreme