Trends and reversions or regressions to the mean are directional concepts within the stock market. Understanding trends and reversions and how to make them work for you as an investor can be important.
A trend is a directional movement of some type that takes time to develop, yet continues until saturation of the trend occurs and eventually flattens the trend. Trends in the stock market are most often referred to as bull or bear markets meaning the general market is moving in an upward directional trend with a bull market and the opposite for a bear market.
Trends occur for various reasons. Within the stock market they are most often the result of major economic growth, recoveries, or slowing, but can also occur in specific sectors due to new innovations such as the technological revolution that has occurred over the last twenty years.
Trends Life Span
Trends can have short or long term life spans. For example fashion trends may last a year whereas a health trend can last multiple years. As an investor it is always best to be on the correct side of a trend. Being on the wrong side of a trend can be detrimental as it’s a battle that is rarely won until the trend turns.
Reversions occur after a big run in an upward or downward direction that is usually accompanied by a large amount of buying or selling. Reversions are a lot like that of stretching a rubber band to its extreme. When the rubber band is released it reverts back to its original form quickly.
Reversions or also referred to as regressions toward the mean definition is a statistical occurance where the greater the deviation of a random variable from its mean, the greater the chance that the next measured variable will deviate less far. In simple terms, an extreme event is likely to be followed by a lesser extreme event.
If the price is an up move, or an increase, the buyers dry up and the owners of the stock that purchased prior at lower prices of the move step in to take profits by selling. With few or no new buyers left at the peak price sellers now drive the price downward. The late buyers to the up move panic, since they are now showing a loss, and add to the selling until the price reaches an equilibrium where the sellers come back and equal the buyers which usually is some point close to the mean, or a lesser move downward.
Reversions general characteristics of high volume buyers or sellers in a stock creates volatility and opportunity. Volatility is usually a sign of uncertainty. Investors that capitalize on reversions have to be cautious of their strategy, so as not to get caught in an actual reversal whereas the price of the stock reverts beyond the mean and keeps going, triggering a reversal of price beyond the mean.
It has been said that trends and reversions are the only two ways to make money in the stock market. From a conceptual point of view this is fairly accurate. Reversions occur often, and in many forms in the market. They can happen to the overall market or to an individual stock. The lesser risk in a revision is usually in the same direction of a trend.
Trends can take time to develop. This is evidenced by the start of a bull market or the failure of a bull market. Volatility usually increases during these periods as price moves ratchet back and forth until one side, the buyers or the sellers, dominate. Being able to understand when a trend is just reverting or reversing is challenging. This is why long term investing and being able to value an investment is important. Doing so can help to minimize the concern of reversions or trends changing, and you being on the wrong side.
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