Business, Legal & Accounting Glossary
Mean Reversion is a theory suggesting that prices and returns eventually move back towards the mean or average. This mean or average can be the historical average of the price or return or another relevant average such as the growth in the economy or the average return of an industry.
Mean reversion is a mathematical theory used in stock investing. This theory suggests that prices and returns ultimately move back towards average or mean. This average or mean can be the historical average of return or price. It can be even any other applicable average like a country’s economic growth or an industry’s average return.
In general terms, mean reversion describes that a stock’s high and low prices are temporary in nature and its price will tend to average across a span of time. In stock investing, mean reversion is calculated by discovering specific stock’s trading range and then calculating the average price.
When a current price of a stock trades below its average price, the stock is regarded as fit to be purchased with an expectation of price rise. If the present market price is higher than the average price of the stock, the price of the stock is expected to dip. In short, departures from average price are anticipated to regress to average.
Mean reversion theory has spawned a number of investing strategies. It is to be kept in mind that a variation in returns means that a company does not have the same prospects as it had in past. There is a reduced chance of reversion in that case. Not only returns and prices are seen to be reverting, but even price-earnings ratio and interest rates also follow this theory.
It is a kind of moving average that is weighted in such a way that recent values are more heavily weighted than values in the historical past. A most common example of weighted moving average is exponential smoothing. Utilization of this kind of moving average gives a better estimate of volatility as compared to simple moving averages.
It is a technique of examining securities by studying statistics produced by activities in the market. Technical analysis includes data like past volume and prices. Technical analysts employ charts and other relevant tools to discover patterns that indicate future stock activity.
Mean reversion is a tendency for a stochastic process to remain near, or tend to return over time to a long-run average value. For example, interest rates and implied volatilities tend to exhibit mean reversion. Exchange rates and stock prices tend not to. Stock market returns, however, do tend to exhibit mean reversion. Exhibit 1 provides an intuitive illustration of the difference between mean-reverting and non-mean reverting behavior.
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Mean Reversion |
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Mean reversion is a tendency for a stochastic process to remain near, or return over time to a long-run average. |
Mean reversion is a model. We choose either to, or not to, model any given quantity with a mean-reverting stochastic process. In some cases, the decision is obvious, as in the examples cited above. Other cases are more subtle. Looking at a time series over a few weeks—or even a few years—may be misleading. Mean reversion may only reveal itself over very long horizons. Usually, a decision to model a quantity with a mean-reverting stochastic process is based both on empirical observation of that quantity over time, as well as some theoretical argument as to why it should be mean reverting.Can you think of a theoretical argument why interest rates or implied volatilities should be mean reverting but exchange rates or stock prices should not be?
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This glossary post was last updated: 30th December, 2021 | 0 Views.