6. Mean Reversion Trading

Why Mean Reversion Occurs in Stocks

A quick thought experiment.

You’re applying a standard momentum strategy to US stocks. It ranks the stocks in your universe based on their risk-adjusted momentum.

You buy the highest-ranked stocks on the list, manage risk using a risk parity framework, and rebalance each month.

Each time you rebalance, you’re going to have some positions which performed very well and grew in value. To stay consistent with your risk parity framework, you have to reduce your position size in these stocks, even though they’re your best performers.

Now assume that most equity momentum strategies are very similar because they basically are. Most of your peers trading the same style will probably own those same high-flying stocks and will also have to trim their position sizes when they rebalance too.

Eventually, all of this selling pressure will combine with an actual shift in market dynamics to bring it closer to its historical ‘mean’. 

This specific situation isn’t alone in its responsibility for the mean-reverting tendencies of stocks, but it’s a good way to demonstrate it. 

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