Tuesday, August 16, 2016

A Simple Market Timing Rule Based on the 200 Day Moving Average

$100,000 Education for Free

This post can probably be written entirely based off of Tony Robbin's interview with legendary hedge fund dude Paul Tudor Jones in the book, Money: Master the Money Game.  Here is an excerpt from that book that sums up Paul Tudor Jones' market timing approach (with some editing used to pull together the thought into one paragraph):
I’m going to save you from going to business school.  Here, you’re getting a $100,000 class, and I’m going to give it to you in two thoughts, okay?  You don’t need to go to business school; you’ve only got to remember two things.  The first is, you always want to be with whatever the predominate trend is...My metric for everything I look at is the 200-day moving average of closing prices.  I’ve seen too many things go to zero, stocks and commodities.  The whole trick in investing is: “How do I keep from losing everything?”  If you use the 200-day moving average rule, then you get out.  You play defense, and you get out.
To summarize, good investors trade with the predominant trend.  That trend is determined by where the SPY, or whatever market you are investing in, is in relation to that 200 day moving average.
  • If the market is trading above the 200 day moving average, you are free to buy assets and hold on to them.
  • If the market drops below the 200 day moving average, you see your holdings and wait that downtrend out. 
Keep in mind, in this definition of market timing you are not trying to predict which way the market is going to go.  Instead, you determine the trend and invest with that trend.  Buy and hold when the market is going up.  Get defensive when the market is heading down.

Here are a couple of images, presented in an earlier post on this blog, about what this looks like:

Market Uptrend: Invest and Hold



Market Downtrend: Get Out and Wait 


Is This Better than Buy and Hold?

People who dismiss market timing outright usually say that a simple buy and hold portfolio performs just as well or better than a portfolio that uses market timing.  They are not wrong.  A portfolio that uses a market timing system like this one does not see a huge increase in percentage gains compared to the returns of the general market.

However, what it does provide is a way to limit the drawdown (or maximum loss) your portfolio experiences.

The issue becomes behavioural.  It is proven that investors have a real nasty habit of selling at exactly the wrong time; when things are at their worst.  When the shit is hitting the fan and the market is at its most pessimistic and prices have dropped huge, people panic and sell everything.

If we as humans are prone to this behaviour, a better strategy is to put in place a process that protects you from these stupid-ass mistakes and guides you to take action when it is required.

For example, sell when the market drops below the 200 day moving average before the real massive sell-off happens.  Sure you might miss out on some of the future upside, but at least you have not thrown out the baby with the bathwater.

At the end of the day, research has shown that portfolio performance is better when a market timing tools is used, as opposed to buy and hold.  A great piece of research on this topic can be found in Meb Faber's "A Quantitative Approach to Tactical Asset Allocation"

Here are couple of images that demonstrate the power of the system.  Notice in the first table that performance is better, but more importantly the MaxDD (maximum drawdown) is a lot lower.  With our human tendency to avoid loss, which often means selling at exactly the wrong time, this simple market timing tool can help you manage that risk.

In the graph, pay attention those flat periods on the red line - that is the period of time the portfolios went to cash and protected investors from the larger drawdowns shown on the blue line.  They are small periods of time in the scheme of things, but if you look closely you will see them (ex. ~1926, ~1946, 2008).

Want More Research?

If that is not enough to convince you that my use of a market timing system is a good idea, then that is good.  You are thinking for yourself (although you are going against the wisdom of Paul Tudor Jones)!

If you want to check out more research on this topic then here are few resources for you to check out:

Alpha Architect

How To Time The Market Like Warren Buffett, Part 2, Part 3

Why Market Timing Is So Hard

Market Timing is Back in the Hunt for Investors

Bad Timing Costs Investors 2.5% a Year  - highlights that people do the wrong things at the wrong times

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