Mean Reversion
The tendency for prices and metrics that stray too far to eventually return to the average — the view that what rose excessively falls, and what fell rises.
In plain terms
Mean reversion is easy if you picture a "rubber band." Stretch it too far and it shrinks back; shrink it too much and it stretches back. The view is that when a price or valuation strays too far from its usual level, it tends to eventually return toward the average.
It is the exact opposite view from momentum (the trend persists). Mean reversion sees "what rose excessively eventually falls, and what fell excessively eventually rises."
What it tells you
Mean reversion comes from the observation that "extremes do not last long." Abnormally high margins and valuations get cut toward the average by competition or a changing environment, and a price that fell on excessive fear tends to find its place.
So when a metric strays far from its historical average, it prompts you to weigh "is this a new normal, or an extreme about to revert."
Formula
mean reversion = the tendency for price, valuation, margins, etc. to return toward the long-run average over time when they stray far from it
What high or low means
A valuation or margin far above the historical average is sometimes read as reversion (downside) risk; far below, as room to recover.
But the crux is where the "average" is and whether the structure has changed permanently. When an industry fundamentally changes, it may not return to the old average.
Mean reversion's biggest pitfall is "this time the structure changed." Buying a declining industry's cheap price thinking "it'll revert to the average" lands you in a value trap where the average itself never comes. (This is a concept explainer, not a trading suggestion.)
"It returns eventually" may be right, but "when" no one knows. It can go to a further extreme before reverting, so using it as a timing tool is risky.
Metrics to read alongside
See it in real stocks
Search US stocks on Stocklore to see Mean and other financial metrics alongside the sector average.
This explanation is for information and reference only and is not a recommendation to buy or sell any security. Investment decisions and their consequences are your own.