What is the Mean Reversion?
Mean reversion is a theory according to which the prices return back to the mean. This mean can be the usual average of the price or any other average like return of an industry or growth in the economy.
Understanding the Mean Reversion
The theory has given way to a number of investing strategies that revolve around the sale and purchase of securities and stocks, where the current performance had a bigger difference, than their historic averages. A change in returns means that the company does not have the same prospects like before, which is the reason why a mean reversion might be in place. The phenomena can occur due to a number of factors like price-earnings ratio and interest rates.
How It Works?
Mean reversion is practiced by different traders, and it won’t be wrong to say that sometimes it acts like a self fulfilling prophecy. As the market changes, it starts to attract a lot of investors that want to go against the crowd. When all the participants are at the contrarian side, the market moves back, and gets it to its old self that is more manageable.
For example, the stocks at Samsung move by at least a dollar up or down every day. If one day the stock increases by $5 and there are no announcements, the mean revisionist will assume that the price of the stock will decrease the next day.
Why Is It Important?
It is a quantitative method of investment and trading that is used by people who are actively involved in the market, some of which are not able to make changes in the market.
Further Reading
- Real exchange rates and purchasing power parity: mean-reversion in economic thought – www.tandfonline.com [PDF]
- Mean reversion in stock prices: Evidence and implications – www.sciencedirect.com [PDF]
- Mean reversion and consumption smoothing – academic.oup.com [PDF]
- Mechanical mean reversion of leverage ratios – www.sciencedirect.com [PDF]
- Mean reversion in stock prices? A reappraisal of the empirical evidence – academic.oup.com [PDF]
- Mean reversion in short-horizon expected returns – academic.oup.com [PDF]
- Nonlinear mean‐reversion in real exchange rates: toward a solution to the purchasing power parity puzzles – onlinelibrary.wiley.com [PDF]
- Momentum and mean reversion across national equity markets – www.sciencedirect.com [PDF]
- Quasi mean reversion in an efficient stock market: the characterisation of economic equilibria which support Black-Scholes option pricing – www.jstor.org [PDF]
- Mean reversion and structural breaks in real exchange rates: South African evidence – www.tandfonline.com [PDF]
