We expound on mean reversion and value investing – its concept, issues and application to investing.

What is mean reversion?

“Regression to the mean” refers to an inverse correlation among roughly normally distributed observations that are made repeatedly over time. An extreme observation at one point in time (“outlier”) tends to be followed by a less extreme observation; extremes, in other words, revert or regress over time towards mean or average measurements.

Mean reversion in financial markets

Investors such as David Dreman and behavioural economists such as Richard Thaler and Werner De Bondt have uncovered strong evidence that regression to the mean, or something akin to it, occurs on financial markets. It occurs at both individual and aggregate levels, i.e., with respect to both individual securities and markets as a whole. Psychology plays a part in mean reversion. Investors have a predilection to linearly extrapolate the future from ...