What it means
Many financial measures wander around an average over time. A stock's price relative to its recent history, a company's profit margin, or the gap between two interest rates can swing high or low, but they often come back.
Reversion to the mean is the belief that extreme readings tend to be followed by more normal ones. There are good reasons for this behaviour in business.
When a company earns unusually high margins, competitors are drawn in and prices fall, and when a sector is struggling, weak firms close, supply drops and the survivors recover. These forces pull results back towards a typical level.
Investors use the idea in several ways. Traders look for prices that are many standard deviations away from their average, expecting them to snap back.
Valuation analysts assume that a very high growth rate or profit margin will fade towards the average over a number of years, rather than lasting forever. A common measure is the z-score, which tells you how many standard deviations a value is from its average.
A reading of 3 is very unusual and may signal a stretched price. A trade built on this idea sells when the z-score is high and buys when it is very low, aiming to profit as the value returns to the mean.
The danger is that the mean itself can change. A company that has genuinely transformed its business, or a market that has moved to a new level of interest rates, may not return to its old average.
Buying something only because it has fallen a long way can lead to losses if the fall reflects a permanent change. Finance teams meet the idea in budgeting and forecasting.
A forecast that assumes an exceptional quarter will repeat is likely to disappoint, while one that assumes a poor quarter will continue may be too pessimistic. Sensible planners blend recent results with the long-run average.
In practice
Real-world examples.
Example
A fund manager notices that a food retailer's profit margin is far above its ten-year average. She assumes that competition will push it back down and values the company on a lower margin. Her valuation is lower than the market price, so she does not buy.
Example
A pairs trader watches two oil companies whose share prices usually move together. When the gap between them widens beyond normal, she buys the cheaper one and sells the dearer one. She closes both when the gap narrows.
Example
A finance director prepares next year's forecast after a record sales quarter. Instead of multiplying the record by four, she blends it with the three-year average. The more cautious forecast turns out to be close to the real result.
Formula
Calculation
Z-score = (current value - average value) / standard deviation
Suppose a share has traded around an average price of $50 over the past 20 days, with a standard deviation of $2. Today it trades at $56. Z-score = (56 - 50) / 2 = 3. A trader who sells 1,000 shares at $56 and buys them back when the price returns to $50 would make (56 - 50) x 1,000 = $6,000, before costs. If the price keeps rising instead, the trade loses money.Case study
Seen in the real world.
Greystone Asset Management is an illustrative, fictional firm that built a model to trade shares that had fallen sharply in a week. The model bought any share that dropped more than three standard deviations below its 20-day average and sold when it returned to the average.
For two years the model made steady small gains, averaging $400 per trade on positions of $50,000. Then a share it bought after a fall was the subject of a fraud investigation and never recovered, and the loss on that one trade was $15,000.
The firm added a rule to avoid shares with negative news. The illustrative lesson is that reversion works when the move is temporary, and fails when the average itself has changed.
Watch out
Common mistakes.
- Assuming every fall will reverse, when some price changes reflect permanent changes in the business.
- Using too short a history, which gives a poor estimate of the true average.
- Ignoring trading costs, which can wipe out the small gains typical of mean reversion strategies.
Questions
People also ask.
Is reversion to the mean guaranteed?
No, it is a tendency, not a law, and it can take much longer than expected or fail altogether.
How is it different from momentum?
Momentum assumes that recent moves will continue, while reversion assumes they will reverse, and both can work in different markets and time periods.
Does RTM always mean reversion to the mean?
No, in sales and marketing the same letters often mean route to market, so check the context before using the term.
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