Moving Average: A Simple but Powerful Tool 1

The light is green… you go. It turns red… you stop. Pretty simple. Wouldn’t it be nice if you had a “red light, green light” indicator for your stocks?

While no indicator is perfect, I have found moving averages to be pretty good. Moving averages are not predictive. Instead, they help you determine—after the fact—a stock’s trend.

First, what is a moving average (“MA”)? It’s the average price for a chosen timeframe—such as 50 days. You would simply add up the past 50 days’ closing prices and divide by 50. Each day the MA changes, as you add one new data point and throw out the oldest one. Thus, each day this average is “moving.”

Then you set a rule. For example: If your stock is trading above its 50-day MA, hold it. If it’s below, sell it. You should back-test your rule to see if it meets your objectives. It might be too sensitive and trigger too many changes. It might be too slow and miss key inflection points. You can back-test using most online charting tools, such as Yahoo Finance.

MAs for Long-Term Investors

I’ve developed a fairly sophisticated trend analysis system using a combination of MAs. It’s mainly for long-term investors who want to avoid protracted downturns. While I’m not about to disclose my methods here, let me give you a simple MA that you can back-test to see if makes sense for your longer term investing.

It’s a 10-month MA. You only use the month-end closing prices—they’re easy to find on your monthly statements. Add up the last 10 prices and divide by 10. If the current month-end price of your stock is higher than the 10-month MA, hold it. If lower, sell.

The chart shows the monthly closing prices of the S&P 500 in black and its 10-month MA in red.

You can see that such a tool would not have gotten you out at the absolute high or in at the absolute low. Repeating: MAs are not predictive—they are trend following. Still, it did a reasonable job of participating in uptrends while protecting from a good deal of the downturns.

Robert A. “Rocky” Mills is a Financial Advisor with the Global Wealth Management Division of Morgan Stanley in Westlake Village. The information contained in this article is not a solicitation to purchase or sell investments. Any information presented is general in nature and not intended to provide individually tailored investment advice. The views expressed herein are those of the author and may not necessarily reflect the views of Morgan Stanley Smith Barney LLC, Member SIPC, or its affiliates. S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market. An investment cannot be made directly in a market index.