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Trend Following: A Strategy That Stands the Test of Time

Buy and hold hope is not an investment strategy. And hoping is exactly what you are doing without a clearly defined and disciplined investment strategy.

Defining a strategy doesn’t have to be complicated. All you really need is the discipline to stick to it.

How uncomplicated? Try following one line.

A moving average is the average price of a security over a period of time. And the 200-day moving average is a trend line that has proven its value as a simple investment strategy over the past 100 years. And the strategy is this simple: when an index is trading above the 200-day moving average, it is time to buy. When an index is trading below the 200-day moving average, it is time to sell.

Tracing this strategy back to the late 1800s, it works (based on backtesting by MarketWatch). The assumption: a fully invested portfolio when the Dow Jones Industrial Average is above its 200-day moving average, and a move to cash when the index fell below the average. A buy and hold approach (notice I didn’t say strategy) would have delivered a 5.1% annualized return, while the 200-day moving average strategy would have returned 6.8%. And remember…this is assuming that the portfolio is sitting in cash, earning nothing at all when the trend line signals a sell.

But the value of this strategy is not just about the returns. Its also about reduced volatility and drawdown. Looking at the strategy (red line) relative to the S&P 500 (blue line), moving into cash (or a cash equivalent) when the index crossed below the 200-day average would have eliminated a lot of volatility (exiting in late 2008, and not re-entering until July 2009).

As the saying goes, “the trend is your friend”. Following the 200-day moving average as a guide is a straightforward, time-tested strategy. All it really takes is the discipline to follow it.

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