Are Moving Averages Financial Sorcery?

As an investor who uses moving averages (along with breakouts) all the time, I have a lot of respect for what moving averages can provide. Proper use of moving averages, combined with other factors, can help an investor be very profitable in their trades.

A lot of investors have a great misunderstanding of moving averages and see them as a predictive tool or just simple market nonsense. They’re compared to a sort of financial sorcery or necromancy—using an interpretation of some abstract force or past information to predict future events. Moving averages are not magical and they certainly do not predict anything with any certainty.

While moving averages are not necessarily predictive, they do help traders filter noise and identify larger price movements. By smoothing the prices of a certain investment over time, it’s easier to see if prices are going up or if they are going down. When the price of an investment is regularly moving higher, it must trade at a price higher than a historical moving average. The inverse is also true.

In itself, this doesn’t mean anything. If you buy when the price moves above a historical long-term moving average, there’s maybe a 50% chance the price will stay above the moving average long enough to be meaningfully profitable. That shouldn’t frustrate you! Winning half of your bets is a great way to play the investing game if your profits are much larger than your losses.

This is where patience and risk management—the important psychological factors in trading—come into play. A trader looking to buy or sell every month or week or day or hour will certainly go broke. A trader that doesn’t size their positions carefully will go broke as well. To be successful you must limit your losses when you’re wrong (trades you make that don’t go your way), while patiently letting your correct trades run on to big profits. In this manner, moving averages help a trader get an idea of when to make bets in an easily controllable way—like betting carefully on a poker hand only when you’re dealt a pair, or two cards that could form a straight.

You could also think of moving averages like a hockey net. A hockey game has only 60 minutes of play, so a team gets a limited amount of puck time and a limited number of potential shots. If a player shoots only at the net, less than half the shots they make will go in. A team could take many, many shots if their players take random shots in all directions every time they get the puck. They will still score every now and then, but the odds drop substantially and there would be a phenomenal amount of wasted energy and effort. Focusing on shooting only at the net when inside the blue-line means limited opportunities, but the odds of scoring are also more favourable.

Trading with Moving Averages

Moving averages—especially when plotted on a chart—can be very confusing for an amateur trader. Lines following other lines, bars, or candlesticks with daily or weekly closing prices bouncing above and below. Traders should limit the number of moving average lines you look at. I prefer just one or two myself. Always keep the chart simple, clean, and specific to your objective.

If all the lines and noise on a chart are clouding your judgement, track daily or weekly closing prices on an Excel spreadsheet instead. Then use an averaging formula to get your moving average price.

If that price was below the moving average line and moves across the line, it could be time to make a buy trade with a stop-loss to limit the downside if you were wrong. Likewise, if you were holding a position that was trading above the moving average line and the price falls below the line, it could be time to sell your position. Using daily or weekly closing prices only is often a good way to limit the price noise that occurs during the trading day.

To use moving averages successfully when trading, you also need to adjust your investing mindset. Many investors start by always looking for a deal, counting it a win if they buy at the lowest price of the day, week, or month. To be a profitable trader, you should instead be happy to buy into rising prices. Purchase aggressively into a rising price environment and try to take advantage of a continued move higher.

“It isn’t as important to buy as cheap as possible as it is to buy at the right time” – Jesse Livermore

Moving Average Timing Periods

First, it’s important to understand there is no magical moving average number to use. There’s a lot of noise out there about the 50-day or 200-day moving average. These are just arbitrary numbers that are designed to sound nice to the ears. Sure, a price falling below the 200-day moving average can indicate a longer-term down movement. Same could be said for the price falling below the 207-day moving average. It’s just that 207 is an odd number.

I often hear professionals make market comments around these popular numbers, saying something like, “Bad things happen when the price is below the 200-day simple moving average.” Well of course! Bad things also happen when the price is below the 5-day, 19-day, 106-day, or 221-day moving averages. I can likewise say the opposite, “Good things often happen when the price is above the 42-day moving average.” That doesn’t make me helpful to anyone—it makes me obvious.

The key to choosing a timing period is to consider how much you want to trade. If you choose a 10-day moving average, you will probably trade at least once a week. If you choose a 300-day moving average, you may only trade once or twice a year.

There’s a lot more variance in trading frequencies when comparing two short-term moving averages than two long-term moving averages. For example, both the 250-day and 300-day moving averages might signal 2 trades per year within a week or two of each other. Meanwhile, the 5-day moving average could signal a trade twice a week while the 50-day moving average might signal a trade only once every month or two.

Many trading signals is likely to mean more “false signals”—or whip-saw trades. This means you need to be more careful about limiting your losses on each trade by running tighter stop prices. You might be able to risk 10% of your position on a long-term moving average that provides a 50% gain in one-third of signals. But you probably can only risk 4% of a similar sized position if the moving average only provides a 15% gain on one-third of trade signals. There should be a positive expectancy between size of losses, size of wins, and percentage of wins.

Long Time Periods

I don’t like the idea of sitting behind my computer everyday watching multiple markets waiting to buy or sell. If I follow 10 different assets and I expect any given asset to send me a trade signal once a week, I could potentially be trading more than once a day. That doesn’t leave any time for golf, reading, cooking, hiking, biking, or naps.

For this reason, I choose long-term moving averages. The 250-day is a good place to start—not because it’s magical or meaningfully different from the 216-day or 262-day, but because it’s a long-term, round number that I’ll easily remember. Also, I know it will send me signals only once every few weeks on all the investments I watch (which are not that many).

Source: TheRichMoose.com, Yahoo Finance

As seen in the 1-year chart above, in a nice upwards trending market I can be in a single position for more than a year without worrying about selling. That’s nice peace of mind! I can go on vacation or otherwise ignore the market for a week without a problem. These big trends are nice and come around often enough. It allows me to catch the big part of a long-term rising (“bull”) market while avoiding those catastrophic year-after-year down (“bear”) markets.

Most traders are probably best served by choosing long-term moving averages. This means at least 100-day, probably more than 150-day, and likely longer than that. It reduces noise and the number of bets you will make.

Short Time Periods

I don’t use short-term moving averages for entering and exiting positions—making those big bets with tens of thousands of dollars each time. The stress and focus I would need to move that much of my net worth around on a daily basis would drive me crazy. I execute all me trades myself; I’ll leave the frequent, big money trading to the nerds running machine algorithms located in offices right next to the exchanges.

After doing some research, I believe short-term moving averages can be very useful to me in risk management—something I’ve been thinking a lot more about in the last few months. For several years I’ve been running a hot portfolio with lots of testosterone and leverage. The big gains were quite nice and paired well with our aggressive savings strategy. But how does one keep those gains while participating in the market? Risk management.

Limiting the size of potential drawdowns through position sizing is important. If your positions are too big, they have an outsized impact on the total portfolio. If they’re too small, they’re not worth holding in the first place. As a position gets really big, thanks to nice gains in an up-trending market, you need a systematic way of bringing the impact of that position back into line considering your overall portfolio equity and risk tolerance.

Short-term moving averages can help with this. Over a period of a few weeks, the price of any given security tends to oscillate around a 10-day moving average. Using a 10-day moving average can identify powerful short term up-trends—a market that climbs very rapidly. We saw a perfect example of this in January 2018 where, from January 2 to 29 (a period consistently above the 10-day moving average), the S&P 500 climbed an incredible 5.86% (104% annualized).

Source: TheRichMoose.com, Yahoo Finance

These big short-term trends come around once or twice a year and should not be missed. However, once the trend is over and the price falls back below the 10-day moving average, it can be a great time to take risk off the table by paring back your position a bit. It probably doesn’t make sense for someone with a moderate portfolio to reduce a position size by just 10%, but if the risk adjustment calculation calls for sale of 25% or more of your position, it is a great time to take some profits.

This use of short-term moving averages is still something I’m experimenting with currently, but I’m liking the results so far. To me it makes sense and is a logical way of addressing the position size problem.

Summary

Moving averages don’t predict anything with any certainty. However, that doesn’t mean they should be discounted as “market voodoo” by investors. They're simply a systematic way of limiting the number of trades you make to try maximize long-term profitability.

Even with proper use of moving average signals, an investor would be lucky to have more than 50% of trades become profitable. However, combined with good risk controls, that could translate to a very successful investment portfolio over time.

Moving averages are a logical way of filtering out market noise and making better, more parameterized bets. A price movement above a long-term moving average can tell you it’s time to make a bet with an appropriate stop-loss. This is because bull markets are always markets where the price trades above a historical moving average. A price movement below a short-term moving average can be a great time to take some profits and reduce your portfolio risk.

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Proper Ways to Use RRSPs

With the March 1, 2018 deadline for RRSP contributions (attributable to 2017 income) fast approaching, let's do a quick review of who should use RRSPs and how to maximize their tax advantages for different purposes.

RRSP Basics

First, it's important to understand what RRSPs are and how they work. An RRSP is a special type of savings account that carries certain tax advantages. RRSP accounts are different from TFSA accounts and non-registered (Cash/Margin) accounts.

You must look at your income tax situation to determine if RRSP accounts should be part of your savings plan. Contributions to your RRSP are deducted off your taxable income. This reduces your income tax owing on your income.

On the other hand, withdrawals from RRSP accounts are taxed as regular income. Any gains or losses on investments that remain in your RRSP account are not reported on your income taxes.

Since RRSPs can be quite lucrative—particularly for higher income individuals—the government has decided to cap contributions at 18% of pre-tax income to a maximum of $26,010 in 2017 (don't want people saving too much I guess). Hopefully one day the government will reform and simplify our tax system so we don't need to deal with special accounts and this limit nonsense; I'm not holding my breath!

If you earned $100,000 in 2017 and contributed the maximum $18,000 to your RRSP, you would only be required to pay income tax on $82,000 for the year instead of the whole $100,000. However, years down the road when you withdraw that $18,000 plus the investment gains earned on that money, you will claim that as regular income and pay tax on it at that time.

In a nutshell, RRSPs do not always save you tax, but they always defer taxes to a later time. To meaningfully save tax, you must contribute to your RRSP accounts when you are in a high tax bracket (earn a high income) and withdraw money from your RRSPs only in years where you are in a low tax bracket (earn a low income).

Good Scenarios for Using RRSPs

I think it’s generally good practice to always try put money into your RRSP—especially if you earn income that’s higher than the second tax bracket (more than $90,000).

For most people this means they should fill their TFSA first and their RRSP accounts after that. (There are some exceptions to this for high spenders or very low earners.)

Standard Retirement Savings

RRSPs are a decent tool for retirement savings. In retirement, you almost invariably earn less taxable income than when you are working. This is because your spending is likely to be lower and you only need to withdraw the funds you require to pay your daily expenses. You no longer need to pay for savings, or work-related expenses. Researchers estimate Canadians spend 20-40% less money in retirement compared to when they are working.

You can also split RRSP income with your spouse, further assisting you in staying in the lower tax brackets. You can do this with Spousal RRSPs or under the current pension income splitting rules when you’ve converted your RRSP to a RRIF.

At some point you must convert your RRSP to a RRIF (age 71 at the latest). After the conversion to a RRIF, you can no longer contribute to the account and you are required to make minimum taxable withdrawals from your account each year. These withdrawals grow year after year and can put individuals with very large RRSP/RRIF accounts into very high tax brackets. It could also result in claw-backs of seniors benefits ranging from Old Age Security to prescription benefits.

If you are using RRSPs for retirement savings, be careful you don’t let your RRSP accounts become too big! Even $1 million per person is probably too big for most people.

Sabbaticals / Stay-at-home Parenting

RRSPs are a great tool to save for sabbaticals. In our society, especially the younger generations, it is increasingly unlikely that you will work the same job at the same company for your entire working career. Taking sabbaticals between career changes is a growing trend.

This is for a few reasons: people are finally doing something to combat boredom at work, job markets and solo entrepreneurship have been relatively robust, the traditional loyal employer-employee relationship is breaking down, and employee benefits are slowly being cut which reduces the golden handcuff effect.

More and more people are refreshing themselves and their careers by taking sabbaticals. It generally means taking a year or two off work to reset your life. On sabbaticals people might travel, go back to school, develop a plan to start a business, spend time with kids, or fulfill any other passion.

Naturally, during a sabbatical, you are probably not going to earn much income. For this reason it’s a great time to withdraw some money from your RRSP at very low tax rates.

If you are planning a sabbatical in your future, save for it by contributing to an RRSP now when you are earning a higher income and use the tax savings to pay for part of your sabbatical.

This same principle applies to stay-at-home parenting. If you are planning on having kids and want to stay at home for a few years to raise them, you can use RRSPs and Spousal RRSPs to both save now while you are working. Then, the stay-at-home spouse (and Spousal RRSP beneficiary) can deplete the RRSP accounts at low tax rates while they are home. I talk more about that in this post.

Adult Education

Along the theme of sabbaticals, RRSPs are also fantastic tools to save for further education. You can use your RRSP to pay for school expenses and living expenses while you are going to school. If you are going to school on a full-time basis, you can also take advantage of the Lifelong Learning Plan (LLP).

The LLP lets you “borrow” up to $10,000 per year, or $20,000 total, from your RRSP to pay for your education. While you must be enrolled in school full-time, the borrowing use is not limited just to tuition or related direct education expenses.

The LLP is great because you do not pay any taxes on the withdrawals! The only catch is that you must pay money back into your RRSP once your education is finished. This repayment is typically done by paying back 1/10th of your total LLP borrowing over 10 years.

If you need more than $10,000 a year while you are in school, you simply make a standard RRSP withdrawal and pay tax on it. Again, your tax rates are likely to be very low if you’re going to school full-time so it's a great way to use tax savings to fund your education costs.

Home Downpayment

When it makes sense for you to buy a house, you can use your RRSP to fund part of the downpayment for the house purchase. The Home Buyers Plan (HBP) let’s new home buyers “borrow” money from their RRSP as a downpayment if they have not owned a house in the prior four years.

The HBP limits your withdrawal to $25,000. However, as with the LLP, your withdrawal is not taxable. This is an excellent way to get money tax-free out of your RRSP and use before-tax money to pay for your house.

HBP borrowing from your RRSP must be repaid over 15 years, starting the second year after you pulled the funds out of the RRSP.

Early Retirement Savings

The RRSP is a fantastic savings account to use if you plan to retire early. Generally people can retire early only because they spend a lot less than they earn. This often means above average income combined with below average spending (a perfect combination for tax arbitrage).

Since RRSP contributions save you money on taxes during your higher-tax income earning years, you can get a big boost by putting as much money as you can into your RRSP when you are employed.

The size issue of having a large RRSP is not a problem for early retirees. If you retire at 50 years old instead of 65 years old, you have given yourself an extra 15 years to slowly whittle down your RRSP before those mandatory RRIF withdrawals kick in.

Since your expenses are likely to be low, your RRSP withdrawals should be at low tax rates. RRSPs are much better than TFSAs if you are contributing at a 40%+ tax rate and withdrawing money at a 15% tax rate.

RRSP Pointers

  • Don’t be afraid to invest aggressively, within the limits of your risk tolerance, in your RRSP accounts. Contrary to some popular misconceptions, RRSPs are not just for bonds or low-growth investments. Total net worth is what counts!
  • Don’t ignore RRSPs because of bad information. RRSPs are much better than saving in a non-registered investment account for the vast majority of Canadians. Chances are you are in that majority.
  • If you make RRSP contributions throughout the year, use a form T1213 to get less tax deducted off your paycheques now and increase your savings all year.
  • Always invest your tax refund! If you don’t invest the tax refund from RRSP contributions, you are taking away the benefit of saving in an RRSP. Tax refunds should be viewed as a temporary loan from the government that you must pay back at some point.
  • Take a serious look at Spousal RRSPs. While current income splitting rules allow you to split any RRIF withdrawals with your spouse when you are a senior, it is a rule that is easily changed. If you earn substantially more than your spouse, or one of you has a defined benefit pension, Spousal RRSPs could be your best retirement savings option.
  • As with all investment accounts, choose a low-cost option like ETFs in a self-directed RRSP account. Managed RRSP accounts and RRSPs with the bank or life insurance company typically come with high fees in their products. These high fees can severely reduce your return on investments over your investment lifetime. You should never, ever pay more than 1.0% of your investment asset value in total fees!

Comments & Questions

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