ASSET CLASS MEAN REVERSION AND THE IMPLICATIONS ON LONG TERM INVESTING

Open Access
Author:
Barone, Nicholas
Area of Honors:
Finance
Degree:
Bachelor of Science
Document Type:
Thesis
Thesis Supervisors:
  • James Alan Miles, Thesis Supervisor
  • Louis Gattis Jr., Faculty Reader
  • James Alan Miles, Honors Advisor
Keywords:
  • investing
  • random walk
  • mean reversion
  • equities
Abstract:
Patterns and predictability of asset returns has always been an intensely debated topic. Some believe in the random walk theory, where successive security returns are completely independent of one another. Others believe and have found evidence of mean reverting tendencies in securities. In this paper, I look to not only review past studies to analyze prior results, but I plan to answer the very question of return predictability through empirical data. Furthermore, I focus more specifically on how this affects the asset allocation of long term investors. With investment horizons exceeding 20 to 30 years, I plan to study how the effects of time diversification work to benefit investors willing to take on greater risk with their capital. If asset classes do indeed tend to revert to a long term mean, truly long term investors should approach asset allocation differently than those with shorter investment horizons (one to five years.) I back test historical asset class returns and interpret the results to formulate a practical investment strategy for long term investors. I also use these historical returns to test return predictability found within three different asset classes: stocks, corporate bonds, and treasury bills. I address the question, do we find mean reverting tendencies within asset classes, and are the effects of time diversification real? If so, how should long term investors best allocate their capital to not only maximize return, but do so without taking on excessive risk?