What is "Mean Reversion"?

Mean reversion is a trading strategy assuming that price will move back to its average price following a temporary price spike or extended price move.

The Basics of Mean Reversion

Reversion to the mean involves retracing a condition back to its long-run average state. The concept assumes that a level that strays far from the long-term norm or trend will again return, reverting to its understood state or secular trend.

This theory has led to many investing strategies that involve the purchase or sale of stocks or other securities whose recent performances have differed dramatically from their historical averages. However, a change in returns also could be a sign that a company no longer has the same prospects it once did, in which case it is less likely that mean reversion would occur.

Percentage returns and prices are not the only measures considered in mean reverting; interest rates or even the P/E ratio of a company can be subject to this phenomenon.