An introduction to reversion to the mean

‘Reversion to the mean’ is a statistical phenomenon where a variable that deviates significantly from the mean or average will likely move closer to the mean over time. This is an outcome of the law of large numbers.

In investments, ‘reversion to the mean’ or mean reversion refers to the idea that the performance of a particular investment or asset class will tend to normalise over time or revert to the long-run mean. So, if a stock, sector, or market index has been outperforming or underperforming the overall market for a while, reversion to the mean suggests that it might eventually start to move to the average over time.

For example, if a particular stock has had a series of very high returns, reversion to the mean suggests that these returns will likely decrease over time, moving closer to the average market return. Conversely, if a stock has been underperforming, it might be expected to provide returns closer to the market average eventually.

However, while reversion to the mean can help understand the behaviour of investments, it’s not a foolproof predictive tool. This is because investments can and do continue to outperform or underperform the market for extended periods, and various factors can influence an investment’s performance. Therefore, while reversion to the mean can be one dynamic an investor can factor in when making investment decisions, it’s crucial to consider a wide range of information or seek the services of financial professionals.

Misinterpretation of mean reversion

‘Reversion to the mean’ phenomenon doesn’t suggest that because a stock has been underperforming, it will necessarily start to outperform. Nor does it imply that an overperforming stock will suddenly plunge. Instead, the principle only suggests a tendency for performance to move towards the average over time.

Some investors misinterpret reversion to the mean as a sort of ‘pendulum swing’—that an asset that outperforms will subsequently underperform, and vice versa. However, the mean reversion principle does not necessarily predict these sharp reversals. It simply suggests a move towards the average, not necessarily beyond it.

Implications of mean reversion in investment methodology

First, mean reversion can serve as a reminder of the importance of diversification. If one asset class is currently overperforming, reversion to the mean suggests that it may not continue to do so forever. By diversifying across different asset classes, investors can protect themselves from the risk of any single asset class underperforming.

Second, the concept can be a valuable tool for assessing the risk and potential return of various investments. For example, suppose a particular stock has been performing well above the average for its sector. In that case, investors may want to consider the potential for reversion to the mean when estimating future returns.

Finally, the principle of mean reversion can underscore the importance of long-term investment strategies. While certain assets may overperform or underperform in the short term, the long-term trends are likely to be closer to the mean. This can help investors focus on their long-term goals rather than getting influenced overly by short-term market fluctuations.

Limitations of reversion to the mean

While the principle of mean reversion is a valuable tool while investing, it’s crucial to be aware of its limitations. Some of them are:

  • Timing is uncertain: While mean reversion suggests that an investment’s performance will eventually move towards the average, it doesn’t indicate when this might happen. An investment can overperform or underperform for extended periods before reversion occurs, making the timing of investment decisions based on mean reversion challenging.
  • Doesn’t account for fundamental changes: Mean reversion is based on historical averages, but it doesn’t account for fundamental changes in a company, industry, or the economy as a whole that could affect future performance. For instance, technological innovation, regulatory changes, or shifts in consumer behaviour can result in new performance averages.
  • Mean is not always clear: Determining the ‘mean’ to which an investment might revert is not always straightforward. For example, the average performance of a particular stock or asset class can vary significantly depending on the time frame you’re looking at.
  • Mean reversion versus momentum: Mean reversion can conflict with momentum strategies, which involve buying securities that have recently increased in value and selling those that have declined. In other words, momentum strategies assume that price trends will continue, while mean reversion assumes they will reverse. Both strategies can be successful, but they can also lead to losses if used at the wrong time.
  • Doesn’t guarantee profit: Even if an asset’s price does revert to the mean, that doesn’t necessarily mean you’ll make a profit. If the price decreases too much before it begins to revert or takes too long to revert, you could still end up with a loss after factoring in the inflation.

Modern Portfolio Theory and reversion to the mean

Modern Portfolio Theory (MPT) is a framework for building a diversified investment portfolio that maximises expected return for a given level of risk.

MPT assumes that asset returns follow a normal distribution and that these returns are based on their long-term averages. This is where the concept of mean reversion comes into play. If asset returns deviate significantly from their mean, the principle of mean reversion suggests that they will eventually revert to this mean over time.

In the context of portfolio construction, understanding the reversion to the mean can help assess the potential risks and returns of different assets. For instance, if a particular asset has been performing significantly above its historical average, the principle of mean reversion might suggest caution, as it may be due for lower returns in the future.

That said, it is crucial to remember the limitations of mean reversion. So we can say that mean reversion is a component of the broader framework of MPT, but it’s just one thread of the gossamer while building and managing an investment portfolio.

Related information

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