If there’s one concept that has consistently helped me find good investment opportunities, it's mean reversion. The idea that, over time, asset prices and company valuations tend to return to their historical average has been an invaluable tool in guiding my investment decisions. Understanding how cycles work and recognizing when prices are out of line with historical norms can give you a significant edge in the market. Today, I want to share how mean reversion has played a role in my investing journey and how you can use this concept to time your investments more effectively.
What is Mean Reversion?
Mean reversion is the theory that prices and returns will tend to move back to their historical average over time. This concept can apply to stock prices, sectors, entire markets, or even economic indicators. Markets are often driven by emotions, leading to periods of extreme optimism or deep pessimism. When these emotions push prices too far in one direction, mean reversion suggests that they will eventually swing back toward the average.
My Experience with Mean Reversion
One of the first times I successfully used mean reversion was during the oil price crash of 2015-2016. Oil prices had plummeted from over $100 per barrel to below $30 in a short period. The entire energy sector was in chaos, and energy stocks were trading at rock-bottom valuations. It was a scary time—headlines were full of predictions about oil staying low forever, and there was a lot of fear in the market.
But when I looked at the historical data, I saw that oil prices had always fluctuated, and while $100 per barrel may have been excessive, $30 was also an outlier on the low end. I picked a few energy companies with strong balance sheets that could survive the downturn and bought in when sentiment was at its worst. Within two years, oil prices had recovered to around $60 per barrel, and the energy stocks I had bought doubled in value. It was a clear case of prices reverting to their mean after an emotional sell-off.
Recognizing Cycles
Another important application of mean reversion is recognizing broader market cycles. Markets are inherently cyclical, and understanding where you are in the cycle can help you make better investment decisions. For example, during the dot-com bubble in the late 1990s, technology stocks were trading at sky-high valuations, far above their historical averages. When the bubble burst in 2000, those same stocks came crashing down, reverting back to more reasonable levels.
I remember in 2009, just after the financial crisis, when everything seemed bleak. Stock prices had dropped dramatically, and many investors were scared to put their money back into the market. But I knew that historically, markets had always recovered after a crash. It wasn't easy to go against the prevailing sentiment, but I started investing in high-quality companies that were trading at multi-year lows. Over the next several years, the market rebounded, and those investments provided substantial returns.
The Lesson: Understanding cycles and having the patience to wait for reversion to the mean can help you capitalize on opportunities when others are too fearful or overly optimistic.
The Importance of Patience
One of the keys to successfully using mean reversion is patience. Markets can remain irrational for a long time, and it’s easy to get frustrated if things don’t turn around quickly. In my experience, it often takes longer than you expect for prices to revert to their mean, but the rewards are worth the wait.
Take the real estate market, for instance. In 2007, housing prices were soaring, and it seemed like they would never come down. But those of us who looked at historical data knew that prices were way above their long-term average relative to incomes and rents. Sure enough, the market eventually corrected, and by 2011, housing prices in many areas had reverted to or below their historical norms. Those who waited for the correction were able to buy real estate at a significant discount, setting themselves up for gains as the market recovered.
Avoiding the Trap of Extreme Valuations
On the flip side, mean reversion can also help you avoid getting caught up in overvalued markets. In early 2021, I noticed that several high-growth tech stocks were trading at astronomical price-to-earnings (P/E) ratios—some as high as 100 or 150 times earnings. The narrative was that these companies would grow rapidly for years, justifying the high valuations.
But history has shown that valuations tend to revert to the mean, and extremely high P/E ratios rarely last forever. I decided to stay away from these stocks, and sure enough, by late 2021 and 2022, many of those high-flying tech names saw significant corrections, with valuations coming back down to earth. This doesn’t mean these companies were bad businesses—many were quite good—but the prices had become detached from reality, and mean reversion eventually took hold.
How to Use Mean Reversion in Your Investing
1. Identify Extremes: Look for times when asset prices are at extreme highs or lows compared to their historical averages. These extremes are often driven by emotional reactions, such as fear or greed.
2. Be Patient: Mean reversion takes time. Just because an asset is mispriced today doesn’t mean it will correct tomorrow. Be prepared to wait, and don’t let short-term market movements shake your conviction.
3. Focus on Fundamentals: Mean reversion works best when you’re investing in assets with solid fundamentals. During periods of extreme pessimism, strong companies with healthy balance sheets are more likely to survive and thrive once prices revert to the mean.
4. Avoid the Hype: When everyone is talking about a particular stock or sector, it’s often a sign that prices are getting overheated. Use mean reversion as a reminder that the market can only sustain extreme valuations for so long.
Conclusion: Staying Ahead with Mean Reversion
Mean reversion is a powerful concept that can help you navigate the ups and downs of the market. It’s not about predicting short-term price movements but rather understanding that, over time, prices tend to move back to their historical averages. By recognizing when assets are trading at extreme highs or lows, and by having the patience to wait for reversion, you can set yourself up for success.
In my own investing journey, the times I’ve benefited most were when I stayed calm during market extremes, trusted the power of cycles, and had the conviction to buy when others were selling or stay away when others were buying without thinking. Mean reversion is about having faith in the idea that cycles are a natural part of the market and using that knowledge to make informed, rational investment decisions.