Mean reversion is the tendency for a number – say, the price of a house or a share – to return to its long-term average value after a period above or below it. For investors this presents an opportunity to buy or sell an asset confident that the price will eventually move up or down towards a long term average value.
For example, the average price earnings ratio for the FTSE 100 since it started is 14. At the height of the dotcom boom the index average shot up to 26, a clear ‘sell’ signal for many investors.
However, logical though this theory is, don’t forget the maxim “the markets can remain irrational longer than you can remain solvent”. In other words, even once you understand mean reversion, predicting when it will occur is not easy.