Mean Reversion

Mean Reversion is a financial theory suggesting that asset prices, valuations, and historical returns eventually return to their long-term mean or average level. It is the opposite of momentum and trend following.

The core philosophy behind mean reversion is that extreme market movements—whether bubbles or crashes—are unsustainable. Assets that have experienced rapid price appreciation are expected to eventually cool down, while distressed assets are expected to recover.

Mean reversion forms the basis of many contrarian and value investing strategies. Systematic portfolio rebalancing is inherently a mean-reverting strategy: by selling outperforming assets and buying underperforming ones, an investor assumes the underperformers will eventually bounce back.

While momentum works well in the short-to-medium term (6 to 12 months), mean reversion tends to dominate over longer time horizons (3 to 5 years). Understanding the interplay between these two forces is crucial for building robust quantitative models.