Using a Simple Technical Analysis Indicator to Guide Asset Allocation Decisions

Abstract

We examine the effectiveness of using a simple technical analysis indicator to dynamically guide asset allocation decisions. Using the 200-day simple moving average of the S&P500 as our technical indicator, we employ two separate strategies. We adopt a “risk-on” asset allocation strategy (larger stock allocation) when the daily price of the S&P500 is above the indicator line, and a “risk-off” strategy (reduced stock/increased bond allocation) when below. In contrast to prior research, when transitioning to “risk-off,” we do not necessarily liquidate all equity, but rather consider other less extreme allocations. Over the 1962–2020 time period, we find that following various “risk-on/risk-off” rules generates excess annual returns of up to 0.58%, after factoring in a marginal trading cost. Furthermore, this strategy also provides a reduction in overall risk for an overwhelming majority of the analyzed allocation combinations. Taken together, almost all 200-day technically based strategies post an increase in Sharpe ratios relative to their respective baseline “buy-and-hold” strategies.

TOPICS: Technical analysis, portfolio construction, performance measurement, risk management

Key Findings

• ▪ Using the 200-day simple moving average as our indicator line, all of the “risk-on/risk-off” approaches outperform (i.e., has a higher Sharpe ratio) the respective “buy and hold” strategy. In both analyzed samples, the vast majority of approaches post both higher Sharpe ratios compared to the buy-and-hold strategies.

• ▪ Across the various starting allocations, metrics generally improve (i.e., higher return and lower risk) as a more extreme move to a conservative risk-off approach is employed.

• ▪ We find that this trading strategy is most effective when the stock market posts negative returns. Conversely, in bull markets, the moving average strategy generally lags the stock market returns.