Mean Reversion
The theory that asset prices and financial metrics tend to return toward their long-run historical averages over time.
What is Mean Reversion?
Mean reversion is the theory that asset prices, valuations, and other financial metrics tend to revert toward their long-run historical average over time after deviating significantly. It underpins contrarian investing strategies, pairs trading, and risk models that assume extreme readings are temporary. While mean reversion has strong empirical support for some metrics like P/E ratios and interest rates, it can be a misleading guide in trending markets where structural change has shifted the average itself.
Example
Historical US stock P/E ratios oscillate around a long-run average near 16x. After expanding to 35x in early 2000 during the dot-com boom, the subsequent bear market pulled valuations back toward that historical norm by 2002, vindicating mean-reversion strategies that shorted high-P/E stocks.