Mean Reversion
The tendency for prices and metrics to return to their average after straying too far — what has risen excessively falls back, and what has dropped tends to recover.
Mean reversion = the tendency for price, valuation, margins and the like to move back toward the long-run average after straying far from it
When valuation or margins run well above the historical average, some read it as a risk of reverting downward; well below the average, as room for recovery.
In plain terms
Mean reversion is easy to picture as a "rubber band." Stretch it too far and it pulls back; compress it too much and it springs out again. The idea is that when a share price or valuation strays far from its usual level, it tends to move back toward the average over time.
It is the opposite view from momentum (trends persist). Mean reversion says "what has risen too much eventually falls, and what has fallen too much eventually rises."
What it tells you
Mean reversion comes from the observation that "extremes do not last." Unusually high margins or valuations tend to get trimmed toward the average by competition or a change in conditions, and prices driven down by excessive fear tend to find their footing again.
So when a metric sits far from its historical average, it prompts the question: "is this the new normal, or an extreme that will soon revert?"
Formula
Mean reversion = the tendency for price, valuation, margins and the like to move back toward the long-run average after straying far from it
What high or low means
When valuation or margins run well above the historical average, some read it as a risk of reverting downward; well below the average, as room for recovery.
That said, it depends on where the "average" actually is and whether the structure has changed permanently. When an industry changes fundamentally, it may never return to its old average.
The biggest trap in mean reversion is when "the structure has actually changed this time." If you buy a low-priced stock in a declining industry thinking "it will return to the average," you can fall into a value trap where the average itself never comes back. (This is a concept explanation, not a trading suggestion.)
"It comes back eventually" may hold, but nobody knows "when." It can go even more extreme before turning around, 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 SEC-filing-based financial metrics alongside the sector benchmark.
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.