Why you should take ‘mean reversion’ into account when buying shares

Julie Brownlee, Fsp Invest, 01 Jun. 2015

Tags: mean reversion, what is mean reversion, cape, cyclically adjusted price earnings, buying shares, investing,

One issue facing investors when they buy shares on the stock market is whether they’re buying at a high price. You don’t want to overpay for a share only for it to correct shortly after you invest.

One way to overcome this problem is to pay attention to mean reversion.

So what is mean reversion? And how can it help you when you invest in shares?

Read on to find out…

What is mean reversion?

The idea behind mean reversion is that everything tends to return to its long-term average.

It’s applicable in most financial markets:

  • The property market: History suggests property prices move towards a long-term ratio of prices to average incomes.
  • The stock market: History suggests share prices moves towards a certain level of valuation.

The key takeaway from mean reversion is that while prices may go higher or lower than their long-term mean over the short-term, at some stage they will revert to their average.

This is a handy concept to bear in mind when investing in shares.

By looking at the long-term average, you can see if prices appear too high or too low. And this can help you decide whether it’s a good idea to buy for the long-term or sell.

Putting mean reversion into practise with CAPE

The cyclically adjusted price earnings (CAPE) ratio is one popular measure that takes into account mean reversion.

What CAPE does is looks at a company’s earnings over a period of ten years and then compares this with the current share price. This is different from the price earnings ratio, which only takes into account the past year of earnings.

It works like this:

  • If you buy when CAPE is much higher than average, in other words the market is expensive, long-term returns can disappoint.
  • If you buy when CAPE is much lower than average, in other words the market is cheap, long-term returns can be strong.

So there you have it. Why you should take ‘mean reversion’ into account when buying shares.

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