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“Hidden in Plain Sight: The Dramatic Impact on Financial Planning and Portfolio Construction When Mean Reversion is Incorporated into Risk and Return Expectations”

The research in this paper challenges conventional wisdom on financial planning and portfolio construction, revealing:

  • Why traditional risk models may be leading you astray
  • How mean reversion can potentially reduce your risk of running out of money
  • Strategies for optimizing your portfolio for long-term growth and stability
A NEW SCHOOL OF THOUGHT

What is Mean Reversion?

Mean reversion is a statistical phenomenon suggesting that equity prices revert to their historical average or mean over time. In simpler terms, after experiencing periods of overvaluation or undervaluation, equities tend to move back towards their long-term average. This dynamic presents a unique opportunity for astute investors to capitalize on the cyclical nature of market trends. 

At its core, mean reversion involves identifying situations where equity prices deviate significantly from their historical average. Investors can then make strategic decisions based on the expectation that these prices will revert to the mean. This approach is particularly relevant in various financial markets, especially stocks.

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how it works

Investment Models & Mean Reversion

Stocks Revert

Prices Can Deviate: Presenting opportunities for investors to capitalize.

Monte Carlo Simulations

Assess Investment Scenarios: Reliance on historical data assumptions and potential inaccuracies.

Incorporating Mean Reversion

Identifying Opportunities: Strategic decisions based on the expectation of a return to the mean.

Block Bootstrap

Resampling with Replacements: Assesses the variability and enhances the statistical conclusions.

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THE ADVANTAGES

Advantages of Incorporating Mean Reversion in Your Investment Strategy

Risk
Mitigation

Mean reversion can act as a risk management tool by identifying potential extremes in asset prices. Investors can make informed decisions to rebalance their portfolios when prices deviate significantly from historical norms, reducing exposure to overvalued or undervalued assets.

Alpha Generating Opportunities

By recognizing the cyclical nature of asset prices, mean reversion allows investors to identify attractive entry and exit points. This information can lead to more strategic buying during undervalued periods and selling during overvalued periods, potentially enhancing overall portfolio performance.

Diversification Benefits

Mean reversion complements traditional investment strategies, providing an additional layer of diversification. This approach allows investors to capitalize on market inefficiencies and trends other market participants may overlook.

Long-Term Value Creation

A mean reversion strategy aligns with a patient, long-term investment approach. Instead of chasing short-term market trends, investors can focus on the fundamental value of assets, contributing to sustained and consistent returns over time.

Traditional vs. Mean Reversion-Incorporated Models

In the world of investment strategies, the choice between traditional and mean reversion-incorporated models can shape your financial journey. Below, we explore key distinctions between the two.

Traditional Investment Strategies

Randomness Assumption

Traditional models often assume that the movement of stock prices follows a random path, known as the Random Walk theory.​

Risk Measurement

Traditional methods typically use the standard deviation of historical returns as a primary measure of risk.

Forecasting Approach

The critical problem with the random walk hypothesis is that it ignores the role of valuations, which create time-varying returns. Forecasting returns do not increase when the market falls or decline when it rises.

Asset Pricing Models

The Capital Asset Pricing Model (CAPM) and other related models use the Random Walk theory to determine the expected return on assets.

Portfolio Construction

Portfolios are often built based on diversification and asset allocation based on the risk profile derived from these flawed models, which do not factor in mean reversion into their long-term expected returns.

Mean Reversion Strategies

Mean Reversion Assumption

This strategy is based on the belief that asset prices and returns eventually move back towards the mean or average.

Risk Measurement

Traditional models underestimate bonds' long-run volatility and overestimate stocks' long-run volatility.

Forecasting Approach

Mean reversion strategies use statistical techniques that consider the historical average return and the likelihood of returns reverting to this average over time.

Asset Pricing Models​

Modified versions of traditional asset pricing models that incorporate mean reversion to predict future returns.

Portfolio Construction​

When incorporating mean reversion, portfolios can be designed to optimize risk and returns.

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