Mean reversion is a financial theory that suggests that over time, prices and returns tend to move back towards their long-term averages or means. In other words, when prices or returns deviate significantly from their historical averages, they are likely to revert back to those averages over time.
This theory is based on the idea that markets are efficient and that prices reflect all available information. When prices move too far away from their historical averages, it is believed that investors will eventually recognize this and adjust their behavior, leading to a return to the long-term average.
Mean reversion is often observed in financial markets, where asset prices and returns tend to exhibit short-term volatility but long-term stability. For example, if a stock’s price experiences a sudden increase or decrease, it is likely to revert back to its historical average in the long run. Mean reversion can also be observed in other financial assets such as bonds, commodities, and currencies.
Mean reversion is an important concept for investors and traders, as it suggests that short-term price fluctuations may provide opportunities for profit by identifying assets that are currently overvalued or undervalued. However, it is important to note that mean reversion is not a guarantee and that there may be factors that can cause a stock or other asset to deviate from its historical average for an extended period of time.
Overall, mean reversion is a useful tool for understanding the behavior of financial markets and can provide insights into short-term price movements. However, investors should exercise caution when making investment decisions based on mean reversion and should carefully consider other factors that may impact the long-term performance of an asset.
