---
title: 5/21/14 – How Moving Averages Can Fail
description: Avoid these three pitfalls when using moving averages.
---

[The Independent Market Observer | Outlook. Opinion. Insight.](https://blog.commonwealth.com/independent-market-observer)

# [5/21/14 – How Moving Averages Can Fail](https://blog.commonwealth.com/independent-market-observer/2014/05/21/52114-how-moving-averages-can-fail)

 Written by [Brad McMillan, CFA®, CFP®](https://blog.commonwealth.com/independent-market-observer/author/brad-mcmillan-cfa-caia-mai) | May 21, 2014 5:30:00 PM

For the past two days, I’ve focused on moving averages—specifically, how investors can [use them as warning signals](http://theindependentmarketobserver.com/2014/05/19/51914-how-to-use-moving-averages-to-avoid-stock-market-losses/) and [how they work to manage risk](http://theindependentmarketobserver.com/2014/05/20/52014-avoiding-drawdowns-how-moving-averages-actually-work/). 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.

[View full post](https://blog.commonwealth.com/independent-market-observer/2014/05/21/52114-how-moving-averages-can-fail)

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