Mean Reversion

Mean reversion is the tendency of asset prices or financial metrics to move back toward their long-term average after extreme deviations. In investing, this concept suggests that stocks which have fallen sharply may rebound, while those that have risen excessively may cool off. Quantitative mean reversion strategies identify securities that appear temporarily mispriced relative to recent history or peers. Signals may be based on short-term price moves, valuation spreads, or statistical deviations from moving averages. Mean reversion is driven by behavioral factors such as overreaction to news and short-term panic or exuberance. It tends to work best in range-bound or volatile markets where prices oscillate rather than trend. However, mean reversion can fail during strong directional markets. Stocks that look “cheap” may continue falling if fundamentals deteriorate, while expensive stocks can keep rising in momentum-driven phases. Because of this, practical implementations often combine mean reversion with filters for trend or market regime. This helps avoid betting against powerful moves. Mean reversion strategies usually require tight risk controls and shorter holding periods. They aim to capture small, frequent gains rather than large directional trends. Used selectively, mean reversion adds a valuable contrarian element to systematic portfolios.