While prices are rising, investors need to maximize their gains. When prices turn down, investors need to minimize their losses.
The problem many investors face is worrying about a bear market during the bull market. Worries can be stopped by switching to cash, but then investors miss gains, and failing to take advantage of market gains destroys potential wealth.
We do believe that it is OK to worry about the state of the market. However, we don't believe it is OK to act on those worries without a plan. Investment actions should be based on plans that react to the market, and the 10-month moving average (MA) is the simplest way we know to do this.
Before we explain why, this chart of the SPDR S&P 500 ETF (NYSE: SPY) can help highlight the importance of this indicator.
The 10-month MA is widely followed. Some investors dismiss the idea as simple, but we have found that simple strategies often work well in the markets. Rather than focusing on difficulty or simplicity, investors should develop a plan and follow that plan with discipline.
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One problem with the 10-month MA can be seen in 2009. The buy signal came late. SPY had gained more than 38% before the 10-month MA signaled a buy more than three months after the bottom. While many investors point to this as a problem, the truth is the signals worked much better than a buy-and-hold strategy.
The sell signal in December 2007 came less than 6.7% below the top. An investor with $10,000 at the top would have sold when their account value fell to $9,330. They would have reinvested that amount at the end of June 2009, and their account would have grown to about $19,335 by the end of October 2013. These values ignore the impact of dividends.
Again ignoring dividends, the buy-and-hold investor's $10,000 account would be worth about $12,865 at the end of October 2013. Even though they missed the bottom, investors who followed the simple 10-month MA signals would be significantly better off than a buy-and-hold investor.
Despite the large gains with this approach, the question investors always have is whether or not they could have done better. We do not believe perfect market timing is possible.
Buying closer to the bottom is possible, but it's not necessary if an investor's goal is simply to beat the market. The most important part of beating the market came from following the sell signal.
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We are currently in a bull market, and this market could last for several more years. It could also end tomorrow. No one knows when the perfect time to decrease exposure to stocks will come, but we believe the right time to do that will be when SPY closes below its 10-month MA.
For now, that level is $164.33, and that will change as the market moves up and down. Just like we don't know when the signal will be given, we do not know the exact price the signal will be given at.
There are other successful market timing strategies, but the 10-month MA is a simple one to follow. We recommend readers decide now what strategy they will use to preserve wealth in the next bear market and then stick with that decision as the market continues higher and eventually turns down.
There is also no need to move fully to cash at any time. Some equity investments are always a good idea. In that case, the 10-month MA triggers a decision to sell some stocks, perhaps 25% to 50% of a portfolio.
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Action to Take --> Prepare for the next bear market now by developing a plan that will both allow you to preserve wealth and reenter the market at some point in the future.
This article was originally published at ProfitableTrading.com
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