Behavioural finance: Mean reversion

Regression to the mean is a technical term for things evening out from extremes; if a variable is extreme on first measurement, it will tend to be closer to average on its second measurement. Our pattern-seeking brains are strongly biased towards causal explanations; this is what makes mean regression a difficult concept for the human mind to grasp: The principles of randomness and regression to the mean rarely make satisfying and vivid explanations. This is why essentially random events are often ascribed causal explanations in the media. This is a powerful idea that underpins certain value and contrarian approaches to investing. We know that shifts in investor sentiment can cause market sectors and stocks to become loved or unloved – this is what sets up the conditions for mean reversion. Pure (unloved) value stocks are those companies that are intrinsically cheap based on a simple “sum of the parts” valuation of their business. Learn more about how mean-reversion fits with various investing styles: (VIEW LINK)