This is part of my intermittent series on price, one of the most important and commonly encountered considerations in investing and trading. For this post, I will talk about one of the theories used in deciding a buy or sell call: the reversion to the mean.
According to Investopedia, reversion to the mean (or mean reversion) “is a theory used in finance that suggests that asset price volatility and historical returns eventually will revert to the long-run mean or average level of the entire dataset”1. From the definition, we can see two things: firstly, mean reversion implied that the price of an asset (or security in our context) would go back to its long term mean or average value. Secondly, we could expand the mean reversion theory to apply on other measures and ratios such as returns, dividend yield, price-to-book, etc.
The gist of mean reversion is that, no matter how much a value fluctuates across a period, it would fall back, or rise up, to its average at certain points in time. In the context of price, investors (and traders) would use it as a tool to determine when to enter or exit a particular security. When the price goes up beyond the average, it is deemed that the security is overpriced and hence it is time to sell, ceteris paribus. Conversely, if the price goes below the average, it is time to (re)enter the counter, ceteris paribus.
Online stock charts, such as those from Yahoo Finance, let you find out what are the average values for almost all securities globally. Called moving averages, there are a few types, and the common ones used are simple moving average (SMA) and exponential moving average (EMA). The difference between these two is that SMA takes in all the values over a prescribed period, while EMA applies more weightage to recent or current values. Some investors/traders use two moving averages, whether SMA and EMA or SMA/EMA over two different timeframes.
Going beyond moving averages, we would be stepping into the realm of technical analysis (TA), in which SMAs and EMAs are just one portion of the entire scheme of things. For this post, I shall not proceed further.
Employing mean reversion via moving averages is one of many indicators an investor has in his/her arsenal, and it must not be the sole determinant in making a buy/sell call. Fundamental analysis (FA) in my opinion is important, especially if you are investing for the long term. A number of investors whom I know utilizes both FA and TA (commonly known as FATA) in making the buy/sell call, which to me is acceptable if the indicators, tools and rationale behind them are sound and valid.
Mean reversion using moving average, just like any other indicators, is backward looking, and we must not forget the common phrase uttered in the investment/trading circle: past performances are not indicative of future results. However, with proper and systematic FA or FATA, whether using The Bedokian Portfolio or other methodologies, you can be considered in the “guesstimate” group of investors who roughly know how things may pan out in the future, as compared to those who rely on little or no analysis at all.
Check out the other posts in my All About Price series.
1 – Chen, James. Mean Reversion. Investopedia. 18 Aug 2021. https://www.investopedia.com/terms/m/meanreversion.asp (accessed 23 Jan 2022)