Market Returns - Simple Improvement

This article will explore one simple technique to improve market returns and reduce risk. The simplicity and improvement are likely to surprise you. 

Market Returns Thus Far

We looked at market returns without diversification and concluded that while the returns were attractive the risk was not. 

This diversification reduced risk to more tolerable levels but reduced returns to where most would consider them unattractive.

The old wisdom that an investor “can eat well or sleep well” has thus far held. Attempts to master the return-risk problem have been somewhat superficial and not very productive thus far. Now we begin the exciting part of this series where we investigate whether eating well and sleeping are truly mutually exclusive.

The tool introduced today may be known to most. It is clearly usable by anyone. Despite these factors, most people do not understand how this tool can produce dramatic improvements.

A Market Filter

A market filter is something that tells an investor when he should be in the market and when he should be out. A filter adds a mechanical aspect to trading. Many investors benefit from the lack of emotion associated with a filter. Often investors get so emotionally invested in markets that their well-formulated plans are abandoned. A filter can make it easier to “stick with the plan”.

Filters can be simple or sophisticated. Numerous technical indicators can be used. Many have been modified to serve as filters. We will look at a simple moving average, the simplest and oldest of technical indicators.

(Click on image to enlarge)

Any average requires a series of numbers. This series is added up and divided by the number of observations to obtain an average. In the case of markets, usually, the closing price is used in the series.

If we add up the last n period closing prices and divide by n, we have created an average. This point is plotted on a chart showing prices. If you do that for all price points on a chart, each date will have a dot representing the average of the last n day prices.

Connect these dots and you have plotted a simple moving average. The illustration to the left reflects daily closing prices and a simple moving average (SMA) based on 200 days.

Characteristics of Moving Averages

There are many types of moving averages — simple, exponential, time-weighted, volume-weighted, etc. For our purposes, only the simple moving average is explored. It is the easiest to calculate and understand. It is also the slowest to react (which many consider a negative and the inspiration for its many forms).

A moving average is a lagging indicator (all indicators are regardless of what is claimed). In the case of a 10-period moving average, it lags because 9 of the numbers in the average are historical and only one is current. In an up-market, prices are increasing and the moving average (eventually) lags behind (it is lower than) price. In a declining trend, a moving average also lags, but it is higher than the current price (older prices are higher than the current price).

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