There has never been a better time to be a DIY investor. You can literally open an account for very little money and trade commission free.
As an investment manager you would think we wouldn’t like this trend but it’s quite the opposite. The more educated investors the better, because an educated investor will eventually appreciate the art and science of risk management.
There are now hundreds of thousands of educated prospects that will reach out when the time is right for financial guidance and professional investment management.
Speaking of risk management, I have been on record saying that every investor should either have a trading strategy to manage risk or be 100% passive and let it ride. The danger zone is in the middle where you likely think about risk management after you have already taken heavy losses.
There are simple technical analysis tools that you can use to control risk. The most popular is comparing a stock or index to its moving average. Easy, yet effective if properly executed.
What is a Moving Average?
The concept of a moving average is quite simple. You are taking the average price over a set period of time that adjusts with each additional period added, hence the term moving.
The most popular example is the 200-day moving average which can be applied to any security or index. In theory, if the price of the investment is above the 200-day moving average, we are in a market uptrend and if we go below then the investment is in a downtrend. We discussed the effectiveness of such strategy in a prior blog post.
You can vary how you use moving averages by tinkering with the time period, using exponential vs. simple, or even developing a simple crossover strategy.
The Moving Average Crossover
You can take the concept of a moving average even further by using moving average crossovers. Simply put, you are attempting to gauge the trend of the market by examining what happens when a short term moving average crosses over a long term moving average.
While you can use any time period, the most popular are the 50 and 200 day moving averages.
The click bait media has given a cute name to the most popular versions of a moving average crossover: The Golden Cross and the Death Cross!
While they sound more like artifacts from an Indiana Jones movie, the underlying concept is very straight forward.
Using our time period examples, a “Golden Cross” is when the 50 day moving average crosses above the 200 day moving average. In theory this signifies short term market momentum to the upside and an upcoming bullish breakout.
In contrast there is the “Death Cross” which happens when the 50 day moving average crosses below the 200 day moving average. In theory this signifies short term market momentum to the downside and an upcoming bearish selloff.
We will let CNBC employ the headline scare tactics around these made up terms. Our goal is to test concepts like this to see if they have any validity as part of a risk management process.
Testing the Theory
The best way to test any “theory” is to turn it into a trading system. In this case we wanted to combine both the “Golden Cross” and “Death Cross” into one actionable trading system. Using the S&P 500 TR as our security (you can’t trade an index; this is for illustrative purposes only) the trading system is straightforward:
- BUY the S&P 500 TR when it’s 50 day MA crosses ABOVE its 200 day MA.
- SELL the S&P 500 TR when it’s 50 day MA crosses BELOW its 200 day MA.
- When in cash the money is invested in a 3-month T-bill.
The hardest part of this test is deciding on a date period because your starting conditions matter. The easiest thing to do is to cherry pick dates that fit your narrative.
I decided to test four different periods ranging in length but still covering a wide variety of Bull and Bear Markets. For this test I went back to 1980, 1990, 2000 and 2010 through 05/31/2020.
Let’s unpack all this data.
- Over the long term, on a pure return basis, this system does a good job reducing risk.
- One would expect less return for less risk, but the system does a good job keeping pace with a fully invested market benchmark.
- During a strong bull market period, like we have had since 2010, a risk reduction strategy clearly struggles to generate returns.
The maximum drawdown stuck out like a sore thumb because I would have expected for this system to do a better job at protecting downside risk. We typically want to see max drawdown at 50% of the overall market for risk management systems.
So, what happened? Well the largest peak-to-trough decline that recently occurred happened to be one of the fastest declines from all-time highs ever recorded.
It takes time for moving averages to change direction and the kryptonite for these systems are quick and ferocious declines.
Do you notice how the 2008 decline isn’t even on this list? The market made a top in October 2007, which was almost 12 months prior to the ugly declines of October 2008 which gave plenty of lead time for a moving average system to work.
For full disclosure, this is simply to illustrate a point. This is not financial advice and these numbers do not reflect trading costs, taxes, fees, or anything else that is important.
An investor will never become an investing hero using these types of systems because they are not designed to generate alpha. They are designed to manage risk and get you on the right side of long term trends.
However, relying on one trading tool is like trying to play golf with only one club, while it can absolutely be done, it’s not ideal. If you want to actively trade to manage risk, you need to be able to use a wide variety of indicators.
There will be times where a single trading strategy is, no pun intended, golden but with plenty of periods of head scratching performance dislocation.