One of the best tools that a portfolio manager can use are moving averages. Why? There are several reasons moving averages can be a portfolio managers best friend if followed and worst enemy if the moving averages are ignored.
First, most portfolio managers are aware of them only when key moving averages are broken to either the upside or downside. But machines are aware of them all the time. Machines drive anywhere between 70% to 80% of all trading each day so they are going to use moving averages as triggers to enter and exit trades.
Ever wonder why sometimes the S&P 500 can motor 20 points in a hour or two when there was no news to cause such a move? Most of the time it is because a key moving average was broken to the upside or downside.
Second, moving averages prevent a portfolio manager from making timing mistakes. For those that were buying stocks in late September, that could have been a career ending mistake. When prices break below moving averages it is time to get cautious. Either move into stocks that are not breaking their moving averages or raise some cash.
In a similar vein, staying on the sideline in early January has proven so far to be a costly mistake. When prices break above moving averages it is time to redeploy capital. Move back into stock that you might have sold 10% to 20% higher or look for new ideas that have caught up with the moving averages you follow.
Third, moving averages are a very simple way to improve on ones decision making process. At Erlanger Research, we have created a variety of trigger indicators which in reality are more complex moving averages. For those that do not have access to such indicators, I might suggest a group of moving averages to follow.
One that I follow in addition to using the Erlanger triggers are the 5, 10, 20, 50 and 200 day moving averages. Why these numbers? A 5 day moving average tracks the action over the last week. A 10 day moving average tracks a 2 week period. The 20 day moving average trading close to one months worth of action. The 50 and 200 moving averages are so popular that is why we follow them. We also like the 65 day moving average because it follows the action over the last quarter.