What is Mean Reversion?
Mean reversion is the financial theory that asset prices tend to return to their long-term average over time. When a stock or market index moves significantly above or below its historical average, mean reversion suggests it will eventually move back. This principle underlies many investment strategies, including contrarian investing and portfolio rebalancing.
Evidence and Applications
Historical data supports mean reversion over longer time horizons. Periods of above-average stock market returns tend to be followed by below-average returns, and vice versa. The cyclically adjusted price-to-earnings ratio (CAPE) has been a useful indicator: when CAPE is well above its historical average, subsequent 10-year returns tend to be lower. Rebalancing a portfolio exploits mean reversion by systematically selling assets that have risen above target weights and buying those that have fallen below.
Key Considerations
Mean reversion does not work reliably over short periods. Prices can remain above or below their average for years, and some shifts represent permanent changes rather than temporary deviations. The phrase 'the market can stay irrational longer than you can stay solvent' captures this risk. Mean reversion is best used as a long-term framework rather than a short-term trading signal.