Managing Risk With Moving Averages | Part 3

Author: Nathan Rowader
Date: March 24, 2015
Category: Financial Planning
Tags: , , ,

In part 1 of this blog series, we looked at using simple moving averages as a guide to determining an allocation to stocks or bonds. The results of our simulation showed that investors can improve their risk-adjusted returns by incorporating a more active approach into an otherwise static investment process. In part 2, we looked at how investors can use low volatility strategies through risk targeting to fit their investment objectives and achieve desirable results. In the final part of the series, we are going to discuss a weak point in my previous analysis (or at least what I view as a weak point) and one that I feel needs to be considered when looking at simulated historical returns. Have you figured it out yet?

Bonds aren’t without risk
In my simulated results, I allocated to stocks when they were above a moving average and to bonds when they were below a moving average. Theoretically, I am suggesting that bonds are a great place to put assets when there is a probability that stocks will decline in value. A large portion of the historical returns of my analysis were generated during bear markets when stock prices were falling. This assumption does have some merit since bonds generally have been negatively correlated to stocks. However, this hasn’t always been the case. My analysis covered the periods from December 1989 to February 2015. By and large, this period was marked by persistently declining interest rates that created a huge bull market for bonds. In fact, during this time period the S&P 500 Index increased by an annualized rate of 7.35% while the Barclays U.S. Treasury Index increased by 6.21% but with 70% less volatility than the S&P 500. Bonds have basically been the trade of a lifetime, and so by incorporating them into my simulation, I am making the assumption that this pattern will continue. Maybe it will, but as I outlined in my white paper, The 5% Problem: Double Jeopardy for Traditional Bond Investors, I don’t think it will. So, let’s see what happens when we remove bonds from the moving average analysis and accept a 0% return for months when we were not invested in the S&P 500.

Simple moving average with and without bonds

12/31/89 – 02/27/15

With Bonds Without Bonds
When the S&P 500’s Return Volatility Return Volatility
Price > 200 Day 10.60% 10.46% 8.11% 10.23%
Price > 100 Day 8.43% 10.25% 5.24% 9.93%
Price > 50 Day 7.28% 10.12% 3.96% 9.74%
100 Day > 200 Day 8.60% 10.98% 6.78% 10.73%
50 Day > 200 Day 10.06% 10.65% 7.90% 10.41%
50 & 100 Day > 200 Day 9.05% 10.51% 6.80% 10.24%
100 Day Crosses Above 200 Day 8.60% 10.98% 6.78% 10.73%
50 Day Crosses Above 200 Day 10.06% 10.65% 7.90% 10.41%
S&P 500 Index 7.35% 14.62%
Barclays U.S. Treasury Index 6.21% 4.47%
Source: Bloomberg
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, by excluding bonds the results are dramatically different and the weaker strategies, like the 50-day moving average strategy discussed in part 2, are nearly cut in half in terms of return. I hope that this is eye opening for you but I would like to point out that it doesn’t necessarily invalidate our analysis from the previous parts of the series. Rather, it just means that to eliminate bias we have to do our homework when looking at historical results. In this case, the previous simulations had a bias that bonds were going to continue to be an excellent source of uncorrelated returns. Despite this bias, we can still use moving averages to construct a risk-targeted portfolio. In the table below, I take the process discussed in part 2 with a simple moving average (SMA) strategy using the 200-day moving average as my guide.

A levered simple moving average strategy

12/31/89 – 02/27/15

Return Volatility Worst Month Sharpe Ratio
Levered SMA Strategy 11.22% 14.36% -20.46% 0.46
S&P 500 Index 7.35% 14.62% -16.94% 0.18
60% Levered SMA Strategy/40% Barclays U.S. Treasury Index 9.49% 8.80% -11.19% 0.55
60% S&P 500 Index/40% Barclays U.S. Treasury Index 7.21% 8.79% -10.21% 0.29
Source: Bloomberg
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.

While I think this result is more realistic and sets expectations where they should be, this strategy could be easily refined further. For example, you could still incorporate bonds into a portfolio but only when they too are above their moving average. In any case, moving averages offer some good food for thought and I hope you find them useful.

See the rest of the series: Part 1 | Part 2

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