By: Steve Smith
In the world of investing advice, the concept of reversion to the mean appears in many forms. It applies well to the ideas of buying low and selling high, by hoping to identify abnormal activity that will, theoretically, revert back to a normal pattern and can be part of an overall trading strategy or applied to specific metrics.
For option traders, it applies to the fact that implied volatility, which is key component to an options price, is a mean reverting statistic. A spike in implied volatility is usually a good opportunity to sell options at a premium.
Stock traders and investors may apply both valuation and technical measures, such as p/e ratios or relative strength index (RSI), to identify opportunities.
The Dogs of the Dow, in which one selects the 10 stocks with the highest dividend yield at the end of one year to own is one of the better known strategies that relies on reversion to the mean concept. The thinking behind this investing advice is companies have a natural, repeating cycle in which good performances are predicted by bad ones and the companies with a high yield have already have stock pricing in the bottom of the business cycle and shares should rebound.
An article from Econompic discusses the bigger picture of how capturing mean reversion can deliver better returns than momentum over longer time periods.
While the year to year performance seems random, this post will weigh the benefit of mean reversion (allocating to risk assets that have underperformed and stack low on the quilt) vs momentum (allocating to risk assets that have worked well and rank high on the quilt).
The chart below shows the same asset classes, but rather than rank the asset classes by calendar year performance, it ranks them by rolling five year returns as of the end of February for each year. I picked end of February simply because that was the last data point.
There is a lot of interesting information here. One of the more interesting aspects is how mean reversion AND momentum can be seen over various time frames.
Asset classes appear to be mean-reverting over longer periods (note the strong relative performance of US equities at the beginning of the 2000’s, the poor relative performance through the mid to late 2000’s, and the strong relative performance we are currently experiencing – while EM and international stocks were the opposite) and asset classes that have done well continue to do well (momentum) over shorter periods (note that if something did well the previous five years, it tended to stick around in the years to follow.
The bottom line takeaway for investing advice is this: rather than having to allocate to an underperforming asset class over the past several years, simply wait for that underperforming / cheap asset class to start performing well.
While you may miss the exact turn, you may be able to capture the longer run success when the asset class starts working without having to deal with the pain that created the opportunity.
Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.
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