What is Mean Reversion?

Mean Reversion is a financial theory that suggests that the prices of assets tend to move back to their long-term average or mean level. Price momentum fluctuates around the average mean, overswinging both up and down before eventually returning to the mean. This theory is based on the belief that extreme price movements are not sustainable over long time horizons.

For instance, if a stock experiences a strong rally that drives its momentum up, it will eventually experience a period of “reverting to the mean”. As the price momentum slows down the price returns to its average value. This concept is commonly used in finance to predict, or trade, future stock prices based on past performance.

Historically, we have always seen reversion to the mean. After stocks have had an unusually great 10 or 20 years, they typically turn in subpar results over the next 10 or 20, and after bad 10- to 20-year stretches, the next 10 to 20 tend to be above average.

James O’Shaughnessy

Though this theory has created a lot of trading strategies we will be discussing how Mean Reversion is relevant to the types of strategies discussed in this blog. I would say Value Investing uses the concept of Mean Reversion more than other investment styles. This is because it is hard to make money on a growth stock as it reverts to the mean on the way down (obviously).

Why is Mean Reversion important to understand?

It’s important to understand the idea behind Mean Reversion, even if you don’t adopt the ideology. In finance, theories are debated, but as Stoic Investors, we don’t want to complicate the path to financial goals. We can bypass mathematical formulas around mean reversion and understand the concept when it comes to highly valued or undervalued businesses.

History teaches that when valuations are extreme, “mean reversion,” a move towards historical norms, is likely. Once value stocks turn, the recovery can be fast and intense.

Robert D. Arnott

Mean Reversion works in two ways. Expensive stocks with high multiples (like the P/E) are pulled down towards the average mean. Conversely, undervalued stocks revert up towards the mean.

The concept is to find stocks that are performing against their historical averages. As mentioned in the previous topic, Intrinsic Value, market price fluctuates up and down the underlying business’s true value. Mean Reversion reinforces this idea as Mr. Market creates continuous price momentum that creates this dislocation between price and value.

Out-of-favour, unloved, undervalued companies that are punished by the market eventually start to rise in favour again. This attracts new capital and value investors, and with this price momentum comes the crawl back up towards the mean.

Think of high-growth stocks with a story that causes the herd to pile in. The valuation is pushed sky-high, creating a bubble that eventually bursts. The ultra-high valuations start falling towards the mean once the momentum slows down.

Reverting to the mean in everyday life.

The concept of mean reversion is present in various aspects of life. For instance, we can consider extreme weather conditions. A few days of abnormal weather usually revert back to normal conditions.

Similarly, inflation, fiscal policies, and interest rates are always fluctuating around the mean. Whenever inflation rises, the government attempts to control it by increasing interest rates which then triggers a series of events that impact the economy as a whole. Eventually, after combating rising inflation, it starts to decrease, reverting to the average mean.

This phenomenon is evident in different areas, from finance to sports to weather. For instance, we can consider how famous people, such as a sports star, can suddenly become the talk of the town after a few successful games. However, all the hype and excitement are usually short-lived and followed by average performance as they revert to the mean.

This is a cycle that we see in different aspects of life. What goes up must come down, and what goes down eventually comes up.

I like to relate this concept to my teenage son. When he starts cleaning his room and helping his mother with household chores, it is usually short-lived as he reverts to the mean of being a typical teenage boy. (It’s okay because my son reads this blog.)

How to apply the theory to Investing?

The mean reversion strategy involves investing in stocks that are not performing in line with their historical averages. Profit is made by taking advantage of the closing of this price momentum as it starts to track back towards the mean.

Investing with the concept of mean reversion is based on determining when to buy under the mean and sell above it. Which I think is the purpose of all sound investing. Buy something low and sell it high.

Mean reversion can be applied based on various metrics, not just percentage returns. For instance, the price-to-earnings ratio (or other ratios or financial metrics) starts to diverge from the company’s historical data. One way to evaluate stock valuation is to compare the multiples of a company against its peers, but also against its average.

It’s important to consider not only whether the current ratio pushes the company to overvaluation or undervaluation, but also whether it will revert to the mean. For example, back to its historical multiples.

However, it’s important to note that just because a company is out of whack from its historical average, it doesn’t necessarily indicate that mean reversion is guaranteed. The idea is always going to be based on the underlying fundamentals and what’s changing, which determines if a business will revert.

We must analyse the likelihood the company will revert to the average.

Where I use the idea, not necessarily as a strategy, is where the company fundamentals are developing, and the business thesis is intact, but the market is impacting the stock. Then, that speculative momentum by pushing up or pushing down the multiples, for example, is what I am concerned with understanding.

Before taking a position in a stock because you believe it will revert to the mean ask the following questions:

• What caused the price momentum, whether up or down?
• If Overvalued: Is it euphoria or can this company grow into the expensive price?
• If Undervalued: Will this attract Value Investors or does it deserve to be punished?
• Is it sustainable and likely to be a regular occurrence?
• Evaluate the cause, this can then help to assess the likelihood of the revert.

Not everything returns to the mean. Undervalued companies that have fallen, may have some assets, or value left but what are the chances they will bounce back? Declining business fundamentals? Evaluate the growth, is it sustainable, is it warranted, or will it come crashing down? Investors need to evaluate the prospects that drive the mean reversion.

Not everything that skyrockets up comes down and not everything that sinks comes back up.

In Summary…

Understanding reversion can be useful in making investment decisions. By understanding price momentum and the factors that contribute to it, such as exuberant human behaviour, we can better analyse the likelihood of reversion. Fluctuations in stock prices usually correct themselves, and the higher the deviation, the higher the chance of reversion.

Reversion to the mean is the iron rule of the financial markets.

John Bogle

This knowledge can help you decide whether to sell when you believe that momentum has pushed stock prices too high. If interest diminishes it could result in a large sell-off as the price crashes back down to reality. Eventually, stocks will return to their average value, as investor sentiment reduces, and momentum slows.

I have personally invested in both growth and value stocks with this approach in mind. I have experienced instances where mean reversion failed to materialise, for example, undervalued companies turned out to be value traps, and high-growth companies generated significant returns soaring to new 52-week highs, creating multi-baggers. In both cases, the financial theory of mean reversion was challenged.

The cycle of boom and bust contributes to mean reversion, with constant fluctuations in expectations. This idea can become a powerful investment strategy by first assessing the likelihood of reversion and then patiently waiting for the value to be recognised before investing. It can also help you to exit expensive companies that you believe have been overvalued.

I believe Mean Reversion is most effective when adopting a Value Investing strategy. Contrarian investment styles are all grounded in this theory. You are going against the herd with a decision and then waiting for the herd to catch up to your thesis. Which at that point creates your profit.