Investors use mean reversion model to make decisions on which stocks should be taken in their portfolios according to their mean values. The first goal of the paper is to test the validity of the mean reversion model in emerging markets. Second, it aims to determine the best portfolio investment strategy on the validity of the mean reversion model. As a result of panel regression analysis, we find that the mean reversion model is valid in all of the emerging countries in the sample. This result implies that emerging markets are not efficient even in weak form. On the validity of the mean reversion model, we find that Max3–Min3 portfolio has recorded the best performance and contrarian portfolio is the best portfolio investment strategy. The paper makes contribution to the literature in terms of providing the information about which portfolio investment strategy has the best performance on the validity of the mean reversion model.
Efficient market hypothesis assumes that the prices of assets reflect all available information and so one cannot consistently gain abnormal returns from investments (Fama, 1970). However, researchers assert that none of the markets can be fully efficient because if investors cannot profit from the undervalued equities, trading will stop and no information comes into the market. In this context, the situation in which the stock prices follow a mean reverting process indicates that the assumptions of the efficient market hypothesis is not acceptable. Mean reversion model, one of the stock price behavior models, assumes that stocks have an average price in the long run and so an investor can identify a trading range for their investments by estimating this average price level. According to the mean reversion model, if the current market price is less than the average price, the stock is considered attractive for purchase, with the expectation that the price will rise. If the current market price is above the average price, the market price is expected to fall.
In inefficient markets, on the validity of the mean reversion model, investors (institutional or individual investor) can get abnormal returns by using different portfolio investment strategies some of which are buy and hold, contrarian and momentum portfolio strategies. In buy and hold strategy, investors buy stock for long run and they do not consider rise and fall in the stock price and adopt passive portfolio strategy. In the contrarian strategy, investors buy stocks for lower prices and sell them when their prices increase. In other words, contrarian strategy states that “try to do the opposite of the market so that when the prices turn to average value, your profit will increase” (Sauer and Chen, 1996). According to the contrarian strategy, stock prices will turn to their average value definitely and due to not selling stocks for lower prices and not buying for higher prices will provide sufficient profit from the investments. On the other side, momentum strategy focuses on the general trend of the market rather than the average values of stock prices. Investors buy stocks in higher prices and sell when they are decreasing so that they catch up to the current trend. Therefore, if investors can combine the mean reverting behavior with accurate portfolio strategies, it is possible to get abnormal returns on investments.
The purpose of the paper is to test the validity of the mean reversion model in the emerging markets and then identify the best portfolio investment strategy on the validity of the mean reversion model. In consequence of the research, investors will decide which stocks they should include in their portfolios in the emerging markets and have knowledge of the best portfolio investment strategy. In this context, the paper makes the following contributions to the existing literature. First, the main hypothesis of the paper has not been tested before in Turkey as emerging markets. Second, the subject of the paper has not been examined before in the emerging markets literature.
The paper is organized as follows. Section 2 summarizes the literature. Section 3 defines the dataset, Section 4 describes the methodology applied. Section 5 discusses the empirical findings. Section 6 concludes.
In this paper, we test the validity of the mean reversion model in emerging markets by applying panel data regression and then in the case of the validity in emerging markets, we identify the best portfolio investment strategy for the period 1995–2010. The main findings of the paper are as follows. First, we find that the mean reversion model is valid in the long run in all of the emerging markets. The speed of the reversion is changing from 30 months to 38 months. In other words, stock prices tend to return to average value in each three years. In this case, long term investments will be risky than short term investments and even if the financial markets have downwrad trend, markets will have upward trend in the future and move around the average value.
Second, the contrarian strategy has the best performance on the validity of the mean reversion model. Momentum portfolio strategy has the second best performance after the contrarian strategy and the buy and hold portfolio strategy has the lowest performance. On the validity of the mean reversion model, while the best portfolio is the Max3–Min3 portfolio which includes three countries having the highest return and three countries having the lowest return, the worst portfolio is the Max1–Min1 which involves the country with the highest return and the country with the lowest return.
According to these findings, investors can earn abnormal returns by using contrarian strategy on the validity of the mean reversion model. This result is expected because according to herd psychology it is known that investors buy stock in higher prices and sell while the prices are decreasing. This finding is consistent with those of Balvers et al. (2000), Gropp (2004) and Serban (2009).
The validity of the mean reversion model implies that the emerging markets are not efficient even in weak form. In the inefficient markets, an investor can earn abnormal returns by using various information. From this perspectives, investors can increase their returns by using the information of stock market price behavior. In further studies Monte Carlo Simulation technique can be use for robustness check.
