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Moving Average: Holy Grail or Fairy Tale - Part 2

June 30, 2009

by Theodore Wong

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

Theodore Wong

Prominent Nobel laureates in economics often point to a large body of evidence that supports the Efficient Market Hypothesis (EMH), which states that no one can beat the markets over the long haul. Many renowned financial experts further declare that passive investing in a diversified index like the S&P500 is the only sensible way to manage money. I respect their opinions but I am unable to verify their claims. By examining the evidence, I show that the Moving Average Crossover (MAC) system offers a superior risk-return profile to a buy-and-hold strategy.

I tested the simplest form of active investing, the MAC system, against a buy-and-hold approach on the S&P500 total return index from January 1871 to April 2009. With no data mining or systems optimization, such that anyone analyzing the same S&P500 database would have made the same investment decisions, this basic trend-following system beats the markets.

"How dare you challenge the Canon of Finance with such heresy as ‘beating the markets?’" the experts are sure to respond.

I must have found the Holy Grail, or else the buy-and-hold logic is flawed!

Before I continue, let me recap my key findings in Part 1. I tested different moving average lengths from 2-months to 23-months. By comparing the results of the best of class (6-months) and the worst of class (23-months) to those of the buy-and-hold benchmark, I can make an objective assessment on the MAC system as a whole relative to the markets.

MAC performances that beat the buy-and-hold benchmarks are in green; those that don’t are in red.

  CAGR Terminal Equity Value Risk-Adjusted
Average Drawdown Maximum Drawdown
Buy-and-Hold 8.6% $84,660 23.8% -25.9% -84.8%
6-Month MAC (Best of Class) 9.6% $319,000 37.4% -2.0% -13.8%
23-Month MAC (Worst of Class) 7.9% $36,683 31.9% -4.0% -14.9%

CAGR is the Compound Annual Growth Rate. Terminal Equity Value is how much $1 invested in January 1871 would grow to at the end of April 2009. Risk-adjusted return is the average annualized monthly return divided by the standard deviation of annualized returns. Drawdown is the percentage decline in equity value from its recent peak.