Definition
Mean reversion is the financial theory that asset prices and returns eventually return to their long-term mean or average level. When prices rise significantly above or below historical averages, they tend to revert. This concept underlies many investment strategies, including value investing (buying stocks below intrinsic value) and pairs trading (betting on convergence of related securities). While useful, mean reversion doesn't specify timing and can fail when fundamental changes occur or during sustained trends.
Example
A stock historically trades at 15x P/E. After a panic sell-off, it trades at 8x P/E. A mean reversion investor buys, expecting the P/E to return toward 15x as fear subsides and fundamentals are recognized.
FAQ
What is Mean Reversion?
The theory that prices tend to return to their historical average over time.
Why is Mean Reversion important?
Mean Reversion helps investors evaluate quantitative analysis and make more informed decisions.