One strategy I have heard people discuss from time to time is using the 200-day moving average as a timing indicator. Stocks are purchased when a broad market benchmark is above its 200-day moving average, and stocks are sold when the market benchmark falls below its 200-day moving average. Though there are variations in the type of the moving average used, the basic premise is the same: Own stocks when the market is above the indicator and sell stocks when the market is below it.

In his fifth edition of Stocks for the Long Run, Jeremy Siegel analyzed whether this strategy is beneficial. He ran the numbers from 1886 through 2012 using the Dow Jones Industrial Average. He applied a 1% band, meaning the DJIA had to be at least 1% above its 200-day moving average to trigger a buy signal or at least 1% below its 200-day moving average to trigger a sell signal. The band is important because it reduced the number of transactions. Without it, an investor would be frequently jumping in and out, driving up transaction costs in the process. Siegel also assumed end-of-day prices were used.

Keeping You Out of Trouble

Following the 200-day moving average timing strategy would have kept an investor out of the worst market downturns. Specifically, the investor would have avoided the large losses endured during both Black Tuesday (October 29, 1929) and Black Monday (October 19, 1987). The strategy would have also helped the investor avoid the 2007-2009 bear market.

Commenting on the results, Siegel observed, “The timing strategist participates in most bull markets and avoids bear markets, but the losses suffered when the market fluctuates with little trend are significant.” He added, “The timing strategy involves a large number of small losses that come from moving in and out of the market.”

Mind the Transaction Fees

Jeremy’s calculations show the 1886-2012 annualized return from the timing strategy dropping from 9.73% to 8.11% once transaction costs are factored in. In contrast, the buy and hold strategy realized a 9.39% return. If the 1929-1932 crash is excluded, the buy and hold strategy looks even better: A 10.6% annualized return versus annualized returns of 9.92% and 8.38% for the timing strategy (without and with transaction costs, respectively).

One advantage the 200-day moving average timing strategy did have was reduced risk. With the exception of 1990-2012, the timing strategy incurred less risk than the buy and hold strategy for every period and subperiod studied. This is due to the avoidance of the market’s big downward drops.

Depending on Your Discipline

There is one consideration not factored into Siegel’s analysis: investor psychology. If an investor lacked cold-as-steel nerves and either failed to sell or buy stocks when triggered, the timing strategy’s performance would be much worse. This is because by not acting appropriately, the investor would have missed out on the benefits the strategy was designed to provide.

This is the inherent problem with all trading strategies. An investor who is psychologically unable to stick with them during turbulent market conditions is always better off with a buy and hold strategy. It does not matter how well a trading strategy has performed in the past; if an investor cannot stick to it in all market conditions, his portfolio will suffer. A simple formula to remember is portfolio return equals strategy performance less transaction costs and behavioral errors. A sound strategy that incurs the lowest combination of transaction costs and behavioral errors is the one that will allow you personally to realize the largest long-term gains.