Base rate

Posted by Bob on January 01, 2005

In Reply to: Base rate posted by Bruce Kahl on January 01, 2005

: : Need help:

: : "The actual (base) rate for mean reversion is very high."

: : What does "base rate" mean here?

: : Thanks!

: This is more of a financial services question that anything.

: The mean reversion strategy is based on the mathematical premise that all prices will eventually move back towards the mean aka the base rate or average return.

: Thus, if a stock is underperforming, its price will move towards its average value when the market rebounds.

: The "base rate" would be the price at which you would want to see the underlying position move towards so the investor would see a breakeven point or profit.

Reversion to the Mean is an interesting concept to consider in many areas, since it plays into our concepts of luck, momentum, gambling and magic. Over the (very) short term, you may birdie a golf hole, but you will not birdie all 18 holes in a round to shoot 54. Instead, over the longer term, you're likely to have some good, some bad, some mediocre holes, and wind up with a score pretty near what you normally shoot. The larger the number of chances, the likelier you are to have average results. The Law of Large Numbers. It also helps explain the so-called "Sports Illustrated Jinx." (The cover of this weekly magazine is doomed to spectacular failure in his or her next game, the story goes.) But if you think of an athlete who has 9 good outings, then one fantastic superhuman result ... which would result in fame and a cover story ... the next week, reverting to the mean with an ordinary outing, would look shabby compared to the expectations set up by the cover stroy.
But it doesn' t end there... Reversion to the Mean can be misused to pluck money from the pockets of the unwary. The example of the stock at the top of this query, for example. If a stock goes suddenly down, a stockbroker might sell a customer with the line "The actual (base) rate for mean reversion is very high." But stocks can (and do) move down and stay there. Or move up and stay there. There's no guarantee that they must revert to a "trading range" with a permanent high and low. Unlike the predictable athlete, the stock of Enron can go down, and down, and down.... Beware.