Foundation of the Mean-Reversion Strategy

Large corporations in fact cannot change radically in a short time frame such as daily, weekly, or even monthly. However, the market value from stock exchanges is never stable. For many reasons stock prices often fluctuate erratically just within a day. Sometimes they are close to the intrinsic values while other times they are far apart.

Investors pursuing this strategy assume that the stock price will approach the intrinsic value in the long run. Thus when the market price is too low relative to its intrinsic value, investors should open a long position and vice versa.

The figure above is an example of FPT corporation’s share price for two months, from March 2022 to May 2022. Assuming the business hasn’t undergone any major changes over the time period, investors who follow the mean-reversion strategy will look for opportunities through the difference between the stable intrinsic value and 30% moving market price.

Intrinsic Value in the Mean-Reversion Strategy

The mean-reversion strategy is intuitive for many investors. It encourages buying a stock when it’s cheaper than its intrinsic value and takes profits on an already overvalued stock.

How does an investor come up with an intrinsic value? It’s beyond the scope of this article, though there are theoretical formulas to calculate intrinsic value. In practice, estimating this value requires significant domain knowledge. In this strategy, intrinsic value will shape the investor’s perspective on any investment opportunity. The following is a suggested action for the example above of FPT with different estimates on intrinsic value:

Completely different actions under the same market are the effects of estimating different intrinsic values.

In short, to master the mean-reversion strategy, investors need to have skills related to estimating the mean, or the intrinsic value.

Investment Risks of the Mean-Reversion Strategy

Although companies often change slowly, it’s not the only factor impacting intrinsic value. Any change in macroeconomics, global markets, government policies, business lines, and competitors can have a major impact on a company’s intrinsic value. Misestimating the intrinsic value can lead to buying shares at a too high price while selling shares at a too low price.

The biggest risk in a mean-reversion strategy is that after years of research, the investor may never find the right approach to calculating intrinsic value.