Mean Reversion

Mean reversion is the tendency for extreme values to move back toward the average over time. An exceptional year tends to be followed by an ordinary one, a terrible year by a rebound.

It is observed frequently in markets. Assets that rose sharply for years tend to return less afterwards, and heavily depressed assets recover. The wider valuations stretch, the stronger the pull.

The caveat is that timing is unknowable. Reverting to the mean describes direction, not schedule, and extremes commonly persist for years.

Not everything reverts, either. When a business has fundamentally changed, its historical average is no longer a valid reference — which is why shares in declining industries do not recover.

The practical application is rebalancing. Trimming what has risen and adding to what has fallen to restore target weights applies the principle without requiring a judgement call. It works better at the asset-class level than for individual shares, since a single company can disappear while a whole market does not.