Posted in Finance, Accounting and Economics Terms, Total Reads: 302
Definition: Mean Reversion
The theory or the belief that the price of a stock will tend to always get back to it’s historical average over time, is mean reversion. When the prevailing market price is less than it’s historical average price, then the stock is supposed to be undervalued according to this theory and therefore, an attractive purchase option given the expectation that the prices would rise.
On the contrary, if the current market price is greater than the historical average price, the stock is considered overvalued and it is expected that the stock price would fall over the days to come and return to the average.
Rationally speaking, a mere average is not enough. A better grade of measurement would be the moving average of the stock price in the recent past. This could be a period of 50 to 100 days. As a matter of fact, even after considering this, one must consider the high and low prices for the period under the study.
The basis of mean reversion is justified but very few classes of assets, for example the exchange rates, are observed to be mean reverting. Even those, are mean reverting over a period of months and sometimes years, in which case it is not of much value to an investor.