Managing Risk With Moving Averages | Part 1

Author: Nathan Rowader
Date: March 18, 2015
Category: Financial Planning
Tags: , , ,

Over the past few months the S&P 500 Index has been zigzagging its way across different moving averages, leading various market pundits to predict a variety of outcomes at each approach. These pundits use terms like “golden cross,” “death cross” or “bullish flag.” For those who are not well-schooled in reading these patterns, this talk can evoke emotions ranging from intimidation to outright exasperation. This got me thinking about the type of information an investor can glean from moving averages and how that information can be incorporated into one’s investment process.

What is a moving average?
A moving average—in its simplest form—is the average price of an investment (such as a stock or index) over a period of time—say 50 or 100 days. Looking at a moving average is a great way to filter out the noise of an investment’s price movement so that you can focus on the general trend rather than the day-to-day price fluctuations. Moving averages also come in a wide array of forms, ranging from simple arithmetic averages to exponentially-weighted averages or even averages adjusted by volatility. Investors can choose a whole variety of moving averages to meet their specific objectives. So, in what ways can investors incorporate moving averages into their investment process?

A “simple” moving average strategy
One simple way to use a moving average is to invest during months when your investment ended the prior month above the moving average and get out when the investment is below the moving average. I tested this strategy using a few different scenarios. In the chart below, I simulate an allocation to the S&P 500 Index when it meets certain criteria and allocate to the Barclays U.S. Treasury Index when the S&P 500 doesn’t meet those criteria.

Simple Moving Average

12/31/89 – 02/27/15

When the S&P 500’s… Return Volatility Sharpe Ratio
Price > 200 Day 10.60% 10.46% 0.57
Price > 100 Day 8.43% 10.25% 0.37
Price > 50 Day 7.28% 10.12% 0.26
100 Day > 200 Day 8.60% 10.98% 0.36
50 Day > 200 Day 10.06% 10.65% 0.51
50 & 100 Day > 200 Day 9.05% 10.51% 0.42
100 Day Crosses Above 200 Day 8.60% 10.98% 0.36
50 Day Crosses Above 200 Day 10.06% 10.65% 0.51
S&P 500 Index 7.35% 14.62% 0.18
Barclays U.S. Treasury Index 6.21% 4.47% 0.35
Source: Bloomberg, 12/31/89–02/27/15
This hypothetical example is for illustrative purposes only and does not represent the returns of any particular investment. Past performance does not guarantee future results.

As you can see, using moving averages as a guide to determine your allocations can lead to better results. In most cases the strategy produces better returns than just investing in the S&P 500 but in every case the risk-adjusted returns as represented by the Sharpe ratio is better. This data provides us with another important tool that can be used in our investment process, which will be the focus of part 2 of this blog series.

Additionally, when looking at this type of analysis, there are some important questions that investors need to ask themselves. There is actually a point of significant philosophical weakness in the analysis above. Can you guess what it is? This will be the subject of part 3 of the analysis.

See the rest of the series: Part 2 | Part 3

RISKS

Investing involves risk, including possible loss of principal. The value of any financial instruments or markets mentioned herein can fall as well as rise. Past performance does not guarantee future results.

This material is distributed for informational purposes only and should not be considered as investment advice, a recommendation of any particular security, strategy or investment product, or as an offer or solicitation with respect to the purchase or sale of any investment. Statistics, prices, estimates, forward-looking statements, and other information contained herein have been obtained from sources believed to be reliable, but no guarantee is given as to their accuracy or completeness. All expressions of opinion are subject to change without notice.

One cannot invest directly in an index.

Nathan J. Rowader is a registered representative of ALPS Distributors, Inc.


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