Is Reversion Statistical?

Abstract

There is no disagreement regarding the statistics of mean reversion. What goes up comes down and vice versa. Campbell and Shiller (1988) said that the simple theory of mean reversion was basically right. Fama and French (1989) also suggest that valuation ratios forecast five-year returns with quantifiable accuracy. It is the failure of reversion (divergence) that has not been reconciled with the expression of reversion. Why is the society so keen to accept reversion as statistical, but its failure as behavioral? John Bogle’s (2001), Star, Comets and the Sun analogy to the idea of reversion around investing styles reinforces the idea, that all failure of reversion is an error while reversion is a statistical reality. The reason Bogle suggests not to focus on investing styles, as markets are anyway going to recoil back to the statistical mean. Thaler (1999), goes a step further explaining reversion failure as driven by behavioral errors. How strong is the behavioral case? Should reversion and diversion both be statistical?

Keywords: Reversion, Divergence, Behavioral Finance