Reversion to the Mean

Written by The Dividend Guy on August 9, 2006

There is a concept in investing that for me has been a bit of a light bulb type moment. It refers to reversion to the mean. What does that mean you may ask (or for you more experienced investors you may ask what has taken me so long to turn on to this!):

A theory suggesting that prices and returns eventually move back towards the mean or average. This mean or average can be the historical average of the price or return or another relevant average such as the growth in the economy or the average return of an industry.

I think about it by using an example of people’s weight loss. Many times you will see people (me included) who have gone on a diet to lose a whole bunch of weight only to gain it all back only a short period later. Many of these people have spent a good part of their lives at the heavier weight and for them the heavier weight is their “mean” or “average” weight. To me what is happening here is the body is simply returning to where it has always been when that weight starts to pile back on.

I believe that stocks do this as well. There will be periods of time when the share price of a stock will be much higher (as judged by the P/E ratio for example) than its average price has been for a certain period of time. Buying stocks when they are showing signs of being below historical averages is really what is being referred to when you hear the term buy low, sell higher. For a really good description of this in action, please check out the BMW Method.


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3 Comments so far

  1. news.fatpitchfinancials.com August 9, 2006 9:32 pm

    Reversion to the Mean…

    The Dividend Guy explores the potential that prices of stocks and returns eventually return to their average. I think this revision to the mean is the “effect” and what is really important to understand as an investor is the “cause” of this phenom…

  2. Hejustlaughs August 10, 2006 11:53 am

    Are you a participant of the Motley Fool community? They have their own “BMW Method” discussion board over there. Not too sure if BuildMWell (guy credited with developing the method) is an active participant anymore.

  3. The Dividend Guy August 10, 2006 1:04 pm

    Yes I am a member - and follow that board quite a bit. I have been seriously been considering buying some more Home Depot based on the discussion.

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