Mean Reversion
The concept of mean reversion is widely used in various financial time series data, including price, earnings and book value. When an asset's current market price is less than its average past price, it's considered attractive for purchase. Conversely, if the current price is above the average, it's expected to fall. Traders and investors use mean reversion for timing of their respective trading and investment strategies.
Mean Reversion
Definition
Mean reversion is the phenomenon where financial time series data (such as prices, returns, and book values) tend to revert to their historical average over time. Simply put, when an asset's current market price is below its past average price, it is expected to rise; conversely, when the price is above the average, it is expected to fall.
Origin
The concept of mean reversion dates back to the 19th century, introduced by British statistician Francis Galton. He discovered this phenomenon while studying genetics, and the concept was later widely applied to financial markets.
Categories and Characteristics
Mean reversion can be divided into two main categories: absolute mean reversion and relative mean reversion. Absolute mean reversion refers to prices or returns reverting to a fixed historical average; relative mean reversion refers to prices or returns reverting to an average relative to a benchmark (such as a market index).
Characteristics:
- Applicable to various financial time series data.
- Relies on the accuracy and stability of historical data.
- May be less effective during periods of high market volatility.
Specific Cases
Case 1: Stock Prices
Suppose a stock's historical average price is $100, and the current price is $80. According to the mean reversion theory, investors might consider this a good buying opportunity, expecting the price to rise back to around $100.
Case 2: Bond Yields
A bond's historical average yield is 5%, and the current yield is 7%. According to the mean reversion theory, investors might expect the yield to decrease to around 5%, and therefore might choose to sell.
Common Questions
1. Is mean reversion always effective?
Mean reversion is not always effective, especially during significant market changes or abnormal volatility.
2. How is the historical average determined?
The historical average is usually determined by calculating the average of data over a certain period, but the length of the chosen period can affect the results.
