Gravity is among the most powerful forces in nature. It keeps us grounded and controls our movements. Similarly, mean reversion is among the most powerful forces in finance. Just as a tennis ball thrown high in the air eventually comes back to Earth, investments that stray too far from their normal path will eventually revert back toward the normal path or mean.
Following a policy of mean reversion allows investors to profit from this evolving dynamic. The main benefits of mean reversion are:
- Proven strategy – Over many years, mean reversion has proven itself. Stocks that rise too fast will either move sideways or decline, and those that have fallen too far, too fast will increase in price. By focusing on long-term trends, investors positioned for reversion will be rewarded.
- Trade the basis – Predicting market direction is very difficult. For this reason, I prefer to trade the relationship, or basis, between items. Mean reversion allows you to position for basis trades and trade against proven price levels.
- Contrarian – When the entire market runs in one direction, a trade becomes crowded. Most investors know they need to zig when others zag and prepare themselves for the eventual countermove. Mean reversion allows you to take contrarian actions by believing the current extreme move will not last and normality will eventually return.
While the benefits of this strategy are clear, there are also risks we must consider. The three main risks are:
- Changing relationships – Markets evolve. If a long-standing relationship is in the midst of changing, mean reversion will not work. Instead of prices reverting, the market will attempt to define a new relationship.
- Unknown timing – John Maynard Keynes famously declared that markets can remain irrational longer than we can remain solvent. Mean reversion is based on a return to rationality. While a trade may be logical, the timing of the market’s recognition may not. Investors expecting quick reversion and instant profits can become frustrated if the trade extends with little indication of impending reversal.
- Entry point – This is the hardest decision to make. Knowing that a trade will work, when do you
enter? Come into the transaction too soon and prices can move against you, coupling
losses with frustration. Look for wide spreads and the trade can revert
quickly, forcing you to miss profitable trades. As always, timing and entry point are key.
Mean reversion is a strategy I use often. By allowing long-term relationships to guide my actions, I can trade comfortably, manage risk, and position for changing markets. While it is an excellent tool for all investors, make sure you understand both the risks and benefits before starting. Doing so increases the odds of success in a dynamic, changing market.
Sean Hannon, CFA, CFP is a professional fund manager.
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