A Simple Way To Use Graphs To Protect Your Investments

Big stock market declines sting. In fact, they hurt you twice. First, when the market crumbles it can take a big chunk of your money with it. And if you’ve ever gone through a steep market decline, the mere thought of going through another one might make you gun-shy with your money. As a result, you might invest far too conservatively for years thereafter. That often ends up costing you more than the loss you incurred during the market drop itself and it’s one of the big problems buy and hold investors face.

It would be great if there was a way to grow your money while reducing the risk.  Is it possible to invest with a safety net to help you get out before the market implodes? Is that asking for too much?

Of course there is no fool-proof investing method.  Everything has risk  But some people try to time their investing by using moving averages.  This is a type of trend following method. And some (but not all) of these people have great results*. Again, there are no guarantees – but let’s take a closer look to see if this strategy holds any water.

What Are Moving Averages?

This is just an average price of a stock or index. To illustrate what a moving average is, let’s look at the 200 day average for the S&P 500 index. All you have to do is add up the closing prices of the index for the past 200 days and divide that result by 200. Each day you update this by adding the most recent day and dropping the oldest date.  Then you plot the results on a graph and compare it to the current price of the stock or index.  That’s all there is to it. And if you don’t feel like doing the math yourself you can also just look up the 200 day moving average (AKA MA) in Yahoo Finance! You can use that site to plot the current price of an index (or stock) against this 200 day MA.  Check out the graph below.  The solid red line is the moving average while the squiggly blue line is plots the daily price.

 

 

How Are Moving Averages Used?

You can use these moving averages to help you decide to buy or sell a stock or index fund. What some people do is buy an index fund when the daily price is above its 200 day moving average and sell if the current price is below the average.  You can see that as the blue line goes below the red line, the investor would sell and once it goes above the red line, the investor buys the index fund again.

What Have Been The Results Of Using This Buy/Sell Rule?

There have been numerous studies that looked at this investment approach and many suggest the system has merit*.  I was intrigued by this, especially for investors who depend on their investments for income.

This theory was tested by Jeremy Siegel in his book, Stocks for the Long Run. He concluded that an investor who used this strategy with the NASDAQ index from 1972 through 2006 would have outperformed the index by 4% per year with 25% less volatility*. That’s a lot of money Pilgrim.

Another study back tested this approach from 1901 through 2012*. They also found that a hypothetical investor using such an approach could have made a lot more money over the entire period. That’s mainly because the person using the moving average to guide their investments avoided some (but not all) of the worst market declines over the last 100+ years. (Again this is hypothetical only.)

Neal’s Notes.   Does this seem like too much work?  If so, you may want to hire someone to do this for you.  If so, let’s talk.

Interestingly, this “timing” approach underperformed the buy and hold investor 50% of the time which is a lot. Specifically, during strong bull markets, the buy and hold investor did better. But during market crashes, the moving average approach protected much more of their capital.  It’s really a question of picking your poison.  No one approach is better for everyone.  Each investor has to weigh the pros and cons and decide for themselves.

Why Doesn’t Everyone Do This?

This approach isn’t for everyone. First of all, the past really is no guarantee of future results. Second, keep in mind that there are many years (one out of two) where this underperforms buy and hold. Also, there are many “false positives” – or times when this system tells you to cash out and it quickly reverses itself. So that short-lived exit and re-entry into the market can be costly.

I think this approach can be smart for the right person. My experience tells me that buy and hold often fails because investors are human and often flee frightening situations – that is just our nature. Using this approach, an investor could be shielded from some of those terrifying situations and thereby, stay invested longer.

Do you think such an approach would be helpful to you? Why or why not?

* http://mebfaber.com/2013/06/07/qtaa-paper-update-manage-your-risk-4/