Mean Reversion

Mean reversion is a theory stating that certain economic and financial metrics tend to revert or return to their original mean levels, despite long-term variations. That is fluctuations or deviations in economic conditions even out in due course. This theory is prominent in finance, especially in investing.

The mean reversion model can be used as a statistical tool to evaluate an asset's value, stock prices, P/E ratio, etc. The main advantage of this theory is that it motivates investors to select an investment, despite the unfavorable conditions, with the confidence that they will make profits in the end.

• According to the mean reversion strategy, financial parameter fluctuations will eventually correct themselves and return to the approximate mean level.
• This is extremely important, especially in investing, as low metrics or constant variations discourage investors.
• This approach mainly applies to metrics that affect the financial performance of a company and its stock. Examples include liquidity ratios, returns on investment, the market price of stocks, etc.
• Many investors adopt the reversion approach as it helps them decide when to buy and sell.

Mean reversion trading strategy is seen as a significant development in investing by finance experts. Apart from being directly beneficial, it also forms the basis for many other investment decisions.

But how does this approach work? First, consider the fluctuations in a share price. Even in a single day, the price keeps changing constantly. Stock prices do not open and close at the same rate. Refer to the graph given below. It provides the details of Apple's stock price over six months from January 18 to July 14, 2022, and at different times on July 12, 2022.

This graph shows that the longer the period, the higher the fluctuations and the greater the deviation from the mean. But on taking the mean of the single-day prices, it would average around $147, whereas the 6-month average would amount to $152. Given the high share price of Apple, the $5 difference can be considered negligible. Therefore, it is safe to say that the mean reversion trading theory holds good for Apple's stock.

However, it must be noted here that investors have confidence in prestigious stocks like Apple, Tesla, Netflix, Alphabet, etc. These stocks give better returns despite tumbling for longer periods. Hence, investors are more likely to use the reversion approach to such stocks.

Similarly, mean reversion applies to economic parameters too. For instance, there is an ideal amount of consumer spending that the government favors. This is because higher consumption and spending would increase inflation, while lower spending would slow down the economy.

Governments handle this situation through policy changes, like expansionary and contractionary monetary policies. They mostly do this by increasing and decreasing the interest rates on borrowing. However, considering the bigger picture, the consumption usually returns to the mean.

So, how does this affect businesses? During times of reduced spending, businesses make lesser profit margins, and during times of high spending, businesses make higher profit margins, compensating for the lower profit. Hence, the mean reversion works like a cycle.

Here are some examples to understand the reversion strategy better.

Example #1

David had held the stock of an internet company XY for over two years when he bought the stock for $15 in 2020. However, following the lifting of COVID-19 pandemic lockdowns and easing restrictions, many people spent less time online, and the stock prices of XY started falling.

XY stock prices went to as high as $120 once, but currently, it was at $40 and still falling. David was hoping the stock prices would average, but the stock did not show any improvements for more than six months. Therefore, he decided to sell the stock and earn a profit when it was still possible.

Example #2

The mean reversion functions like a cycle, eventually averaging out. Sometimes, businesses make high profits, sometimes lower profits, thus compensating for the loss. However, Bloomberg News states that, in the past three reversion cycles, businesses have reduced their cost of production, increasing profitability to a record high.

Recently, during times of less consumption, firms have increased their profits by reducing costs. However, even at times of high consumption, the cost has been kept low. As a result, the profit, which should increase with sales revenue, has increased with a decrease in cost. Economists view this as an end to the mean reversion model of consumption.

Mean reversion trading facilitates many investors to make important buying and selling decisions. It also helps companies gain, even if their current performance is not up to the mark. However, the approach might not hold good for every market and every investor.

The strategy motivates investors to hold or buy a low-priced stock, hoping it will perform well later. But it is necessary to remember that many factors affect a company's performance – legal, environmental, political, etc. Such factors contribute to the image of the company and its finances.

Suppose a financial issue, like increased debt, forces the share prices to go down. If the situation doesn't improve, then there is no point in holding on to a stock. A bankrupt company will seldom be able to liquidate its assets and pay off its equity shareholders.

For example, consider the case of Enron Corporation. Its shares traded at $90 in August 2000 and plunged to $0.60 by the year ended 2001. The company finally ceased its operations in 2007, owing to bankruptcy. Or, take the example of Nokia. At the peak of its prosperity, it traded at around $62. Two decades later, its current share price is $4.4.

History tells us many such stories. However, any investor who is in for the long run will evaluate many aspects, learn from the experiences, study the past, and invest wisely. Also, not all the stories out there are demotivating ones. Some work well too.

This has been a guide to Mean Reversion and its definition. Here we explain the strategy of mean reversion, examples, formula and limitations.. You may learn more from the following articles -

• Statistical Evidence
• Statistical Analysis
• Inferential Statistics