The insightful investor understands mean reversion. It is a mystery concept for most – fancy talk.
I will attempt a commonsense explanation with some relevant examples. In conclusion, I will show why this is important.
The Technical Definition
Wolfram MathWorld is a great source on issues like this:
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Reversion to the mean, also called regression to the mean, is the statistical phenomenon stating that the greater the deviation of a random variate from its mean, the greater the probability that the next measured variate will deviate less far. In other words, an extreme event is likely to be followed by a less extreme event.
Please note the specific condition of a “random variate.”
The Use in Finance
In the financial world, it is commonplace to enhance your arguments about investments with technical jargon. Many readers or viewers get lost along the way. Let me start with a popular application of the concept, the pairs trade.
Suppose that your study of stocks in a specific sector identifies some candidates that you believe to be overvalued and others that are undervalued. This can be an ideal situation for a pairs trade. By going long the cheap stock and selling short the expensive one, you eliminate both the overall effect of the market and also the trends in the specific sector. Your trade focuses on the valuation difference between the selected stocks. You might choose Coke (KO) and Pepsi (PEP) or Ford (F) and GM.
Here is an illustration using GLD (the gold SPDR, representing the actual metal) and GDX (the gold miners).
Notice how deviations in the series closed up during the period from 2009 through 2011. Since then, the trade has not worked very well. If you have been implementing it since the start of 2012 it has been expensive. You might have doubled down, tripled down, or stopped out your position and re-entered. You might have decided to question your original assumption about the relationship between the two. Sometimes the miners hedge their positions by selling gold futures, for example.
