474% Since 1995: The Magic of Moving Averages
| So how can investors remove emotion from the equation and make better decisions? One way is to adopt and stick to a system that makes key trading decisions for you. This topic is far too big for a single article, so I'll just provide one example that might be relevant to those of you who are trying to catch a bottom here. The magic of moving averages Using moving averages is an excellent way of detecting major trend changes before it's too late. A moving average is a line on a chart that smooths out a trend. For instance, a 200-day moving average continually plots a stock or index's average closing price of the last 200 days. This provides a smoothing effect and clearly reveals the underlying trend because it ignores the market's day-to-day fluctuations. Let me give you an example of how moving averages can be used to time tops and bottoms in the stock market. The chart below is a weekly chart of the S&P 500, an index of 500 U.S. stocks. I've plotted two moving averages on this chart, namely the 30-week moving average (wma) and the 65 wma. Because the 30 wma reacts more quickly to trend changes, a change in the market's direction will cause the 30 wma to cross below or above the much slower 65 wma in the direction of the change. Crossovers like this can be used as objective buy and sell (or short) signals for the overall market. Here are some rough figures I ran this morning. If an investor had bought the positive crossovers (shown by blue up arrows) and shorted the negative crossovers (blue down arrows), they would have seen the following results: January 1995 - Buy (960 points) January 2001 - Short (495 points) August 2003 - Buy (350 points) February 2008 - Short (375 points so far) This would have resulted in an overall 2,180 S&P point gain from an original investment of 460 S&P points. This translates into a 474% gain over 12.75 years, which is a 37% annualized return! Not bad for only 4 trades. Putting it all together A strategy like this requires patience and discipline. For instance, we've heard several times from the media this year that "the financial crisis is over." Those who listened bought too early and paid dearly. To use a system like this, one needs to turn off the news, tune out the noise, and make trades based purely on the charts. History is the best teacher in things financial, which means that the best way to create systems is to look at history. As you can see from the chart, we're nowhere near having a positive crossover, and so it may take many months before the market gives us a buy signal and starts moving higher. Prudent buyers might wait for this cross-over to occur before loading up on their favorite shares. It should be noted that U.S. stocks took approximately nine months to bottom after the last bear market before they started a new uptrend. Plotting various moving averages over historical charts and then calculating the results (like I did above) can be a profitable experiment. I discovered the above system in this way. Using moving average cross-overs to time investments can work nicely for long-term investors, but it can also work well for short-term traders. Several day traders I know use various moving average cross-overs as buy and sell signals on their 5-minute and 15-minute charts. These often give multiple buy and sell signals a day, which keeps them fairly busy. If you'd like to try plotting the above moving averages on a chart of the S&P 500, the process is quite simple. Here's a set of instructions. (1) Go to www.StockCharts.com. (2) Enter the index symbol ($SPX) and hit "Go." (3) Scroll down to Chart Attributes and change the "Daily" period to "Weekly." (4) Change the Range from "Fill the Chart" to "3 Years." (5) Change the Size from "460" to "Portrait." (6) Scroll down to Overlays and change the "50" to "30" and the "200" to "65." (7) Hit the "Update" button, and you're done! Conclusion Do you think that the Wall Street insiders who have been making countless millions over the years understand and use long-term moving averages? You bet they do! Seldom do they share their secrets with the rest of us, which is probably why systems like this still work. Whatever you choose to do with your investments over the next few weeks and months, just be careful. This is not an easy environment to make money, which makes it an excellent time to review your current strategy and ask yourself if it's up to par with your expectations. ****************************************** To sign up for our FREE EMAIL NEWSLETTER, visit our main page at http://www.HomemadeInvestors.com. Disclaimer: Homemade Investors is published by Homemade Investors LLC. The information contained in this article does not constitute personal investment advice and is not designed to meet the personal financial needs of any individual. Investors should seek advice from a qualified investment advisor before entering into any transaction. The information contained in this article is deemed reliable but is not guaranteed. The information and opinions contained in this article are subject to change without notice, and there is no obligation to update such. To republish this article, visit http://www.HomemadeInvestors.com/reprint for guidelines. © 2008 Homemade Investors LLC. All rights reserved. |
Homemade Investors
| by Daniel R., Homemade Investors Monday, October 20th, 2008 Trading with a system Some of the most successful investors in the world don't spend a lot of time thinking. Why, you ask? Because they have a system that does much of the thinking for them. And this is precisely what gives them their advantage. Think about it for a moment. Most investors base their trading decisions on their emotions, which tend to be incorrect at important junctures. When the Dow broke above 14,000 points last October (the peak), how many investors do you think called up their broker and asked them to sell everything? Probably very few. On the other hand, when the Dow broke below 8,000 a little over a week ago, how many investors do you think called up their broker in a panic and asked them to hit the sell button? Probably quite a few. It's too early to tell if the bottom made on Friday, October 10th will last. I'm inclined to think that the market will consolidate for a few days or weeks and then probe the lows of the last bear market (2003), which would take the Dow down to the 7,200 to 7,600 area. No one knows for sure. One thing is clear though: selling early in a bear market is key to preserving your wealth, as anyone with a 401K can tell you. Likewise, buying early in a bull market is desirable as well, obviously. |
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