Mean Reversion and a Historical Look at its Impact on the VIX

  • Posted by on February 10th, 2013 at 8:10 pm

The Chart below is from the 2013 Credit Suisse Global Return YearbookIt shows the number of trading days the $VIX has taken to revert from its peak level to its mean level after a specific $MACRO crisis.

By far, the 2008 Credit Crunch/Lehman crisis required the most trading days for the $VIX to revert back to its mean. For example, the $VIX took nearly double the amount of days to revert to its mean after the Credit Crunch/Lehman crisis than after the October 1987 Crash.

What some may also find interesting is the time it took for the $VIX to mean revert after the Eurozone and Greek Crises. In both instances, the $VIX reverted back to its mean faster than the average of all the crises listed on the chart.

In trading and investing, mean reversion suggests a stock will likely return to its average price if it is currently trading far above or below its average price.  

Behavioral Economists Daniel Kahneman and Amos Tversky have looked into the concept of mean reversion. They were once told by the Israeli Air Force that reward was more effective than punishment when it came to influencing a pilot’s ability to fly. The Air Force came to this conclusion because each time they rewarded a pilot for a great flight, he tended to do worse on his next trial. And when they punished a pilot for a poor flight, he tended to do better on his next trial.

Kahneman and Tversky saw that this was actually a case of mean reversion and that the reward/punishment system was having little impact. Instead, the pilots who flew great were reverting back to their average on the next trial, and the pilots who flew poorly were also reverting to their mean on the next trial. To quote them:

“We normally reinforce others when their behavior is good and punish them when their behavior is bad. By regression alone, therefore, they are most likely to improve after being punished and most likely to deteriorate after being rewarded. Consequently, we are exposed to a lifetime schedule in which we are most often rewarded for punishing others, and punished for rewarding.” (p. 251).

 

See: The 2013 Credit Suisse Global Return Yearbook via Abnormal Returns



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