Wednesday, August 20, 2008

200 Month Moving Average-an opportunity to test the system

A friend recently sent me an article which highlighted the significance of the 200 month moving average (mma). The article asserted that if the S&P 500 were to drop another 20% it would hit the 200 mma, an event which has happened only a few times in the past century. Each time, it marked a massive bear market.

My friend went on to remark that this was a scary thought, being only 20% away from such a marker. Ok, that seemed like a reasonable, if dour, sentiment. At the same time, the market didn’t seem that bad to me.

He then went on to say that this would mean that if you bought the market using dollar cost averaging over the past 16.6 years (200 months), it would mean you would have received zero return over this period. Not quite… perhaps he meant to say that if you had bought the S&P 500 at the average price for the 16.6 years you would have no return. The two statements may sound pretty similar, but there is a world of difference. Dollar cost averaging implies that you buy more when the market is down and less when it is up. The result is decreased risk, as well as profit from taking advantage of volatility.

To get a quick check on the logic, I checked my 401-k, where I use an advanced form of dollar cost averaging. I reduced the balance by 20% and checked the return over the last 16.6 years. The result surprised even me, resulting in about a 9% annual return over the period. I expected a positive result, but that seemed too good to be true.

That had me doing a bit more checking. I downloaded the monthly closing prices of the S&P 500 for the past 16.6 years, adjusted for dividends and splits. Sure enough, it seemed to confirm the assertion of the article…the 200 mma for the S&P 500, according to my calculations, was about 24% below the current average. But it also revealed a few other things. The 200 mma was about 140% above the level of 16.6 years ago. In other words the 200 mma was so high because the market rose significantly in the ‘90s and has been relatively flat to downward since. It also meant that any balance in the S&P 500 16.6 years ago would have increased about 5.4% per year if it had just been left alone to grow.

Time to check what ordinary dollar cost averaging would have done to an equal investment each month in the period. When I ran those numbers, it turned out that dollar cost averaging would have also resulted in an annual return of about 5.4% on the dollars invested in the period.

All pretty positive when compared to the thinking that hitting the 200 mma meant effectively a no return market for 16.6 years, but still significantly lower than my returns. So, it was back to the drawing board to explain the outperformance of my portfolio.

I use dollar cost averaging on steroids… investing in several markets and using long term projected returns to buy when the market is below the projection and sell when it is above. Many of the markets I trade would be difficult to trace back 16.6 years, but I downloaded the S&P Midcap and Smallcap history. Sure enough, these indexes had significantly outperformed the S&P 500 ( I had to use the midcap as a proxy for smallcap for a few months, since that index doesn’t go all the way back that far). I calculated that they had returned 6.6 and 5.8% respectively in the past 16.6 years. Although significantly better returns than for the S&P 500, it still didn’t come close to explaining my returns of about 9%. So, I set up a simulation of my “dollar cost averaging on steroids” system, in which I started with 210 units about 16.6 years ago, with about 60 invested in each index and 30 in cash. Then, I simulated investing 1 unit each month for the period, using my system(buying when each market was below trend and selling when above). This resulted in a current balance of 1270, for an annualized return on investment of 8.4%, reasonably close to my actual results, considering I invest in several other indexes as well as those simulated, mainly using the same system.

Despite the fact that I’ve been preaching the merits of this system to all who would listen for several years, I’m impressed with the results. This kind of returns, in what by some measures, might be considered a poor market, is pretty amazing. Of course, investing in indexes which are doing better than the S&P 500 is part of the explanation, but that is part of the system…spreading the risk with broad diversification. The fact that this result is obtained using an easy, mechanical process and basic index investing with minimal effort makes it even more remarkable. When you consider that you get decreased risk and volatility in the bargain, it is pretty hard to beat. And, it justifies my claims that it is easy, in fact almost automatic, to beat the market using this system.

Of course, if you could guess the right market to be in and effectively jump onto the best market trends, you'd do even better. But few can do that consistently. This system helps you do something close, with ease. And it allows you to sleep at night.

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