![]() Prices are likely to experience a positive shock for a period of time before reverting to pre-shock values. For example, consider the news that Apple recently introduced a new iPhone model is revealed to the public. This shift can be the result of events such as positive or bad news. Investors understand that unexpected highs or lows might actually signify a shift in the character of the stock. Therefore, the theory of mean reversion focuses on the reversion of only very dramatic changes. Normal growth or other variations are assumed to be part of the paradigm. Interest rates and even a company’s P/E ratio can be affected by this phenomenon. As a result, mean reversion does not just include percentage returns and prices. In that case, mean-reverting is less likely. However, a shift in returns might simply indicate that a firm no longer has the same prospects it previously did. For example, acquiring or selling stocks or other securities whose recent performance deviates significantly from their historical averages. This notion has given rise to a plethora of investing techniques. The theory suggests that a level that deviates significantly from the long-term norm or trend will revert to its recognized state or secular trend. Reversion to the mean is the process of returning to a condition more in-line with the long-run average state. Mean Reverting – The Basics of Mean Reversion However, it is likely to be followed by a less dramatic event that causes significantly less volatility and is in the direction of the stock’s long-term average. In other words, an extreme event can increase or decrease a stock’s momentum. The larger the divergence from the mean, the more likely the next movement of asset values will be in the direction closer to the mean. For example, economic development, stock volatility, a firm’s price-to-earnings ratio (P/E ratio), and the average return of an industry. This mean level can exist and can be applied in a variety of circumstances. It implies that asset price volatility and historical returns will ultimately revert to the dataset’s long-run mean or average level. Mean reverting, reverting to the mean, or mean reversion are all phrases used to describe a statistical theory that is employed in finance. Share on Digg Share Mean Reverting – What Is Mean Reversion?
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