Mean Reversion and its Importance in Investing/Trading

April 8, 2021

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Strategic Alpha

Mean reversion applies to different contexts such as economic growth, volatility, and asset returns. Mean reversion in the context of stock returns implies that the returns will eventually revert to the long-run mean.  It implies that periods of above-average performance in stocks will be followed by periods of underperformance and vice versa. 

Let’s take the example of returns from Sensex over some different periods. The returns from Sensex from the lows of March 2020 up to March 2021 were around 90%. The returns from Sensex from the highs of 2008 up to the lows of 2020 were less than 2% p.a. If you just take the first statistic, it would create an unnecessarily positive expectation about long-term returns from Sensex. If you just take the second statistic, it would create unnecessarily negative expectations about the long-term returns from Sensex.

Now, what mistakes did many investors commit during the 2008 financial crisis when the market crashed? Besides panicking, many would have just looked at the low stock returns in the last few years and sold off their investments. If they would have understood that returns would mean revert, they would have held their investments. 

Let’s take the case of many mutual fund investors who have invested in equity funds and tend to switch schemes. They look at the scheme performance of the past few years. If it is under-performing, they move to schemes where the performance of the past few years is good. Now, an interesting thing happens in many cases due to mean reversion. The scheme which they have exited starts performing well and the mutual fund scheme which they moved to, starts under-performing! What is the lesson to be learned? Rather than jumping from one equity scheme to another due to short-term performance, they can remain invested in the same scheme for a much longer period.
Fund Performance Or a Strategy Performance is transient in nature.  In Long Run, All sound strategies will make a decent return on Investment. For a Common Investor, it’s hard to pick a Mutual Fund Scheme or Stock which will start performing as soon as he/she starts investing.

What are the returns from Sensex since 1979? The returns from Sensex since 1979 are around 16% compounded annually. If the theory of mean reversion were to be applied to Sensex returns, it means that the long-term return expectations from Sensex should be around this number. However, it has to be noted that there are many debates around this number where some people argue that this number is lesser. 

Now let’s move to some individual stocks. The returns from HUL from 1999 up to 2009 were merely around 4.3% p.a. So, it did not move much in the period of 10 years. The returns from 2010 up to 2020 were around 22% p.a. If we take the entire period from 1999 up to 2020, the returns are around 13.5% p.a. 

Commodities follow a long-term price trend. However, during commodity super-cycles, the price of commodities trades above its long-term average. Similarly, commodity prices also remain depressed for long periods.  As per the theory of mean reversion, there will be a rise in the price of commodities in the next few years. This will benefit metal companies. 

During bull markets, there is a huge rise in stock prices with stupendous returns. But, these are followed by bear markets where prices are depressed. But, if we invest for the long term, the returns would be in line with the long term mean.

Also, a Period of Long Underperformance in an asset class will lead to a period of Outperformance, if the mean has to be achieved leading to Mean Reversion. This Mean Reversion Concept if Understood Rightly to pick Selective Mutual Funds where investing in the theme makes sense from many logical points or Selective Stocks where investing in them provides a business growth comfort and stocks available at a discount can help one achieve supernormal returns as one will be riding the outperforming period towards the mean.

In the case of trading, the underlying assumption in a mean reversion strategy is that if there is a big move in stocks, it will reverse partly. Alternatively, if there is a big fall in stocks, it will also reverse. In such a case, since we know that the move will reverse, we can buy the stock. 

Though mean reversion is an important concept, it needs to be applied using common sense and discretion. Also, the future may be different from the past. 

I Have Applied Mean Reversion Theory in Practice by Investing a big Chunk of my portfolio in Old Economy Stocks looking forward to the next 3-5 Years.


You can go through the links given below to know how I have practically implemented the concept of Mean Reversion  in Investing

https://strategicalpha.blog/2020/04/19/bull-market-leaders-create-fortune-why-there-is-a-strong-case-for-old-economy-stocks-to-be-upcoming-bull-market-leaders/

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The author of the blog Mr.Suyog Dhavan is a Full-time Investor / Value Trader and Value investing/Trading Mentor. His style of Investing is inspired by Mohnish Pabrai, Peter Lynch, and Porinju Veliath. He is the founder of Strategic Alpha Wealth, A Premier stock market mentorship firm with a mission to touch the lives of 1Lakh people through its mentorship program.

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