but Better than ‘Buy-and-Hope’
March 3, 2009
Guarding against uncertainty
If you recognize the existence and potential effects of unknown unknowns you understand the concept of uncertainty. It then becomes logical for you to employ an investing process that will limit your exposure to the stock market, where history has shown uncertainty to be the omnipresent catalyst of both triumph and ruin.
To protect yourself from bear markets, you need a defensive strategy — a process that will tell you when there is too much risk and uncertainty. You want to know when to own stocks and when not to. You need a trigger for your buy and sell decisions.
Establishing your buy/sell decision-making process isn’t hard. The challenge is having the discipline to follow it. The obvious analogy here is a fitness routine. Creating the exercise program is easy, but success hinges on execution.
Once you find an investment process that puts the odds in your favor, stick with it. It’s best to remove all emotion from your process and focus on execution rather than short-term results. Understand the roles of time, probability and market cycles. Like passive investors, active investors must be patient and dedicated to their long-term plan.
Choosing an indicator
Your indicator — the analytical tool that tells you when to buy or sell — is the backbone of your decision-making process. There are a number of good indicators that have outperformed the stock market on a historical basis. One I like for its simplicity and effectiveness is the ten-month moving average.
The ten-month moving average can be displayed as a line on a chart showing the history of a stock index, such as the Standard and Poor’s 500 Index. If the line that represents the S&P 500 is above the line that represents the ten-month moving average, you have a “buy signal.” If the line that represents the S&P 500 is below the line that represents the ten-month moving average, you have a “sell signal.”
The chart above covers the last ten years and shows three lines: the performance of the S&P 500 (blue line), its corresponding ten-month moving average (red line), and a hypothetical investment portfolio (green line) that used the ten-month moving average to generate buy and sell decisions as described above. Over this ten year period, the annualized return on the S&P 500 was -3.0%, versus +7.0% if using these buy and sell signals. What’s more, the active strategy had a lower standard deviation. It was only exposed to stock market volatility 63% of the time. So the active strategy delivered higher return and carried less risk!
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