The Truth About Moving Averages

Not a day goes by in the media where the moving average of a particular investment isn’t referenced. Oftentimes, the market’s current level is referenced in terms of where its 200-day of 50-day moving average is, using that as a justification to buy or sell. Below the moving average? It’s a downtrend…sell, SELL! Above the moving average? It’s an uptrend…buy, BUY!! (For the uninitiated, read "How to Use a Moving Average to Buy Stocks?")

The truth is not anywhere near as elegant as these simple conclusions make it seem. Many people use moving averages as part of their analytical toolkit, but few have a true understanding of what the moving average actually tell you. As we show in our 2016 Dow Award winning paper “Leverage for the Long-Run” (click here to download), the moving average indicator doesn’t actually tell you anything about trend. If it did, then in the 1990s, 2000s, and current period bull market (three of the strongest “uptrends” in history), a strategy of buying the S&P 500 (SPY) when above the 200 day moving average and going into Treasury Bills when below should have substantially outperformed a do-nothing approach. In fact, nothing could be further from the truth, as a simple backtest proves.

So are moving averages then completely pointless to look at? Not at all. While the reasoning often referenced for following the moving average is to follow the “trend” (false), the moving average does help with risk mitigation (true). When trading above a moving average, an investment’s volatility tends on average to be lower than when below it.

Why does volatility matter? Because for the vast majority of investors, buy and hold is a fallacy. Volatility and fast moving declines in markets tend to scare money out of markets, causing drawdowns and loss of capital. Volatility management is crucial because it is volatility that causes emotional selling, which more often than not happens at the exact wrong time. (Related: read "Volatility's Impact on Market Returns.")

Your ability to stick to a strategy matters more than the strategy itself. To the extent that moving averages can help lessen that potential volatility in your portfolio, the truth is you should focus on it. Just understand first and foremost what the moving average tells you first.