Mean reversion is a financial theory that suggests that over time, the prices of assets tend to revert to their long-term average or mean. In other words, when the price of an asset deviates significantly from its mean, it is likely to eventually return to that mean.
This theory is based on the idea that markets are efficient, and that prices are generally determined by supply and demand forces. However, these forces can sometimes lead to overreactions or irrational behavior, causing prices to deviate from their long-term average. Mean reversion suggests that this deviation is temporary, and that the asset price will eventually return to its long-term average as the market corrects itself.
Mean reversion is often observed in financial markets, and is used by investors and traders to make investment decisions. For example, if an asset’s price has deviated significantly from its long-term average, a mean reversion trader might expect the price to eventually return to that average, and might take a position in the asset accordingly.
A simple example of mean reversion can be seen in the stock market. Let’s say that the average price of a particular stock over the past 10 years has been $50 per share. However, due to some temporary market factors, the current price of the stock has risen to $80 per share, which is significantly higher than its long-term average.
A mean reversion trader might take a contrarian view and expect the stock price to eventually revert to its long-term average. They might take a short position in the stock, expecting to profit as the price falls back towards the average.
As market forces correct the temporary factors that caused the stock price to rise, such as a change in company performance or a shift in market sentiment, the stock price may start to decline, eventually reaching the long-term average of $50 per share. The mean reversion trader would then exit their short position, having profited from the price correction.
Of course, mean reversion is not a foolproof strategy, and there are many factors that can influence asset prices in the short term. However, over the long term, mean reversion can be a useful framework for understanding market dynamics and making investment decisions.