What does that mean? Reversion to the mean is a statistical phenomenon. It’s the idea the further something is from the mean – or average – the more likely it is the next thing that comes along will be closer to the mean. For example, if a golfer normally plays to par but plays three over par, it’s likely that player will finish better in the next game (unless, the player’s in a slump, but that is a different topic).
Reversion to the mean is the theory behind a variety of investment strategies. Analysts who employ the theory may look at an average price, an average return, or another financial statistic they find relevant. For example, they may consider whether a company’s recent performance varies significantly from its historical average performance. If its performance is worse than average, some analysts may decide the company’s price is likely to revert to the mean. In that case, they may choose to invest in the company. If the company’s performance is better than average, analysts may decide to sell shares. Similarly, if a market or index – such as the FTSE 100 – performs significantly worse than its mean, investors may decide better performance is ahead, and vice versa.
In 2009, an article in Forbes stated, “Mean reversion is an odd concept because it’s clearly not causal. The market’s historic return of 9 percent a year is based on over 100 years of data (what’s typically considered the modern stock market), and, of course, the ride to 9 percent is a bumpy one with major double-digit up years and big double-digit down years all averaging to that 9 percent number.” The point is any average is a moving target. After all, a significant downward movement pushes the historical mean lower and a significant upward shift pushes it higher.
Regardless of the investment theories employed by analysts and money managers, investors may want to set financial goals, carefully choose asset allocation strategies, hold well-diversified portfolios, and maintain their long-term perspective.