The Independent Market Observer

5/21/14 – How Moving Averages Can Fail

Posted by Brad McMillan, CFA®, CFP®

Find me on:

This entry was posted on May 21, 2014 1:30:00 PM

and tagged Economics Lessons

Leave a comment

For the past two days, I’ve focused on moving averages—specifically, how investors can use them as warning signals and how they work to manage risk. Today, we’ll talk about their potential costs and drawbacks, which are common to any type of risk management program.

Problem 1: Missing out on returns

In a sustained bull market, any time spent on the sidelines can be costly. Using a tactical model underperforms a buy-and-hold strategy when the market is rising over long periods, so any risk-reduction plan can result in lower returns.

I wrote a paper on this a couple of years ago and concluded that the difference was in the initial valuation level of the market. For expensive markets, tactical made sense; for normal or inexpensive markets, the costs of risk management usually outweighed the benefits.

That usually is the real caveat here. Over any time period, in any market, risk-reduction strategies may successfully reduce risk, but at the cost of lower returns. Depending on your goals as an investor, this may be a failure.

Problem 2: Quick drops in the market

Markets sometimes drop too quickly for this type of strategy to work. The 1987 crash is a great example, as is the 2010 flash crash. Using moving averages works best when the danger is approaching slowly—they’re more like a hurricane warning than an earthquake warning. In certain situations, this limitation can lead to failure.

Problem 3: A jumpy market

When the market is bouncing around a critical level, this technique sometimes subtracts value rather than adds. We saw this in 1994, when the moving average signals were in and out on almost a monthly basis. Performance was terrible, and the signals provided no meaningful information.

Of course, nothing’s perfect

These limitations don’t mean moving averages aren’t useful. As a risk identification tool, they can add real value, as long as you understand their strengths and weaknesses.


Subscribe via Email

New call-to-action
Crash-Test Investing

Hot Topics



New Call-to-action

Conversations

Archives

see all

Subscribe


Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.

The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.

One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.

The VIX (CBOE Volatility Index) measures the market’s expectation of 30-day volatility across a wide range of S&P 500 options.

The forward price-to-earnings (P/E) ratio divides the current share price of the index by its estimated future earnings.

Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided on these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®