Mean Reversion

Definition

Mean reversion is a statistical concept suggesting that over time, the price, returns, or other financial metrics of an asset will revert to its historical average. This concept is widely used in analyzing financial time series data, helping investors determine the timing for buying or selling assets.

Origin

The concept of mean reversion originated in statistics, first introduced by Francis Galton in the 19th century. Galton observed that extreme values in natural phenomena tend to revert to the mean, a concept later applied to financial markets.

Categories and Features

Mean reversion can be applied to various financial metrics such as stock prices, yields, and price-to-earnings ratios. Its feature is that when asset prices deviate from their historical average, investors can expect them to revert to the mean. The advantage of this strategy is its simplicity and the availability of historical data, but its disadvantage is that it may not be applicable when market conditions change.

Case Studies

A typical case is the U.S. stock market after the 2008 financial crisis. During the crisis, many stock prices fell significantly below their historical averages. Investors used mean reversion strategies to buy at low prices, and as the market recovered, stock prices gradually returned to average levels. Another example is Japan's Nikkei Index, which remained below its historical average for a long time after the 1990s bubble burst. Investors used mean reversion strategies to buy at low points, waiting for the market to recover.

Common Issues

Common issues investors face when applying mean reversion include changes in market conditions that may render historical averages irrelevant, and prices may continue to deviate from the mean in the short term. Additionally, mean reversion does not consider fundamental changes in the market, which may lead to incorrect investment decisions.