In the context of investment performance, what does 'mean reversion' suggest?

Mean reversion is a concept in finance that posits that asset prices and historical returns eventually revert to their historical averages over time. This theory implies that if an asset has deviated significantly from its historical average return—either positively or negatively—it is likely to move back towards that average.

In the context of investment performance, mean reversion can affect various asset classes, suggesting that extreme performance, whether exceptionally high or low, is temporary and will correct as conditions normalize. This can be particularly relevant for investors when making decisions about entering or exiting positions based on recent performance trends.

For example, if a stock has outperformed its historical average significantly in a short period, mean reversion implies that its returns may decline in the future, moving back towards the historical average. Conversely, if a stock has underperformed, there is a possibility that its returns could improve and revert upwards toward its average.

In summary, the idea is that while returns might experience fluctuations and volatility in the short term, they tend to return to their mean over the long run, guiding investor expectations and strategies.