In praise of moving averages

1 October 2016

What do you want the stock market to do for you? Make short-term speculative gains, or grow your wealth over a period of years? My answer would be: ideally both — but the wealth part is by far the more important of the two. The-question is: what can a wealth-seeking investor do to minimise the risk of losses along the way? Here’s one technique that might help.

The starting point is to recognise that the stock market — to borrow a phrase recently used by one MP about the Governor of the Bank of England — is an ‘unreliable boyfriend’. It is emotionally unstable and prone to violent fits. The prices quoted in the market every day are far more volatile than the fundamental facts about economic life they are supposed to reflect. In the last 20 years there have been two spectacular bear markets. On each occasion the stock market has fallen 50 per cent and then rebounded by between 70 and 100 per cent. Yes, profits and the wider economy took a hit in both cases, but the hit was temporary and nothing like as sharp as the market movement.

And it is ever thus. Professor Robert Shiller, the Nobel laureate economist, has researched the-history of market returns and found that if investors 100 years ago had enjoyed perfect foresight into what company profits and dividends were going to be over the next century, the market would never have yo-yo’d around as dramatically as it has. Fundamentals just don’t change as often or as fast as share prices.

But given the instability of investors’ decision-making, those savage market corrections are bound to come round at regular intervals. Would it not be comforting if there was a way to make sure you missed the worst down-draughts while still capturing most of the gains in the up years?

There is no absolutely foolproof way to ensure that, but a few tricks can help. The key is to tune out the daily noise that spews from the media every day and concentrate on longer-term trends that determine how much your wealth appreciates over time. Those trends can be difficult to follow unless you know where and how to look for them, but one very simple way is to use moving averages of main market indices such as the FTSE 100 or FTSE All-Share.-Professionals commonly use a 200-day-moving-average —the-average price at which the index closed over the previous 200 trading days, thus capturing about 8.5 months of a typical year’s market action.

Plotting the moving average on a chart — easy to do on almost any stock market website — will give you a snapshot both of the broad direction in which the market is moving and where today’s index level stands in relation to recent history. For example, the chart on this page shows the ten-year picture for the FTSE All-Share index. The jagged line is the weekly price movement, while the smoother single line is the 200-day moving average.

Now for the interesting part. In an ideal world, ignoring daily movements, your aim would be to be in the market when the 200-day average is rising and out whenever it is clearly falling. It is particularly important to be out of the market when the index has fallen decisively below a falling 200-day moving average, as invariably happens in the worst bear markets.

Looking at the chart, and using only month-end prices, that simple rule would have taken you out of the market in late 2007 and kept you out until mid-2009. You would have taken a break in mid-2011 until early 2012 (the eurozone crisis) and again from mid 2015 until Q2 this year. Post-Brexit, you would still be in the market — and so far handsomely rewarded for it. Even though you miss the first part of each new bull phase, you’re still comfortably better off than if you had stayed fully invested all the way through.

An American analyst, Meb Faber, has analysed what would have happened if you had consistently adopted a similar technique in the US stock market since 1901. He uses a ten-month rather than 200-day moving average, but that does not affect the result by much. The results are striking. An investor who followed this course would have generated higher returns and lower volatility, with much smaller-periodic losses, than anyone who remained fully invested throughout the markets’ ups and downs.

The great beauty of this kind of approach is that it requires very little effort. You need only to look at the market’s level once a month and make a simple binary decision at that point: stay in or pull out. The moving average tells you what to do. You don’t have to listen to pundits or open a newspaper.

It’s fair to say that investment professionals hate this kind of approach, which you can also apply to other asset classes such as bonds, property and gold. Market timing, they will tell you, is a sin — which it is if you are trying to move in and out on the basis of your or their judgments of whether the market is under or over-valued. Nobody I know has ever been able to make that work consistently.

It is also true that this kind of rule-based investing, attractively simple as it is, is most useful when your investments are held in a tax wrapper such as an Isa or a Sipp. Buying and selling your entire holding once a month, easy though that is easier to do these days if you use ETFs or index funds, becomes potentially expensive if you have to pay capital gains tax along the way. For many moving-average investors that is not a problem, though, given the generous annual-tax-free allowances on offer.

So there are some difficulties, but in my experience tracking the moving averages of the market indices, even if you only use them to monitor your portfolio, has proved an invaluable help over the years in-judging where we are in the market cycle. Try it out on paper first if you don’t believe me. Its great merit is cost-effective simplicity— and that’s good for your peace of mind as well as your wallet.

This article first appeared in the Spectator in October 2016. Link here