Let’s begin with a scenario.
You’re attending a stock market investment conference at which you hear a talk given by a renowned financial analyst in the cannabis sector who rose to prominence as one of the first to recommend buying shares in cannabis-related companies.
During the presentation, the analyst speaks optimistically about the cannabis sector’s performance outlook and strongly recommends buying stock in a company that has recently gone public. Inspired, you consider following this advice. But is that the right decision?
Of course not. In my opinion, your intention to buy in that case isn’t based on a proven investment strategy or a quantitative evaluation of quality, but rather on the concept of “social proof.” According to social psychologist Robert Cialdini, we tend to trust the behaviour and opinions of others when faced with making a decision in situations in which there is no clear correct choice. Who hasn’t turned to a friend, a co-worker, or even a taxi driver to ask about the new neighbourhood restaurant?
However, it’s important to conduct your own analysis. Doing so will help you sharpen your skills and knowledge and maintain your intellectual independence. I suggest following this rule of thumb for active trading to improve your success rate and manage risk more effectively.Buy and retain a financial instrument only if it is trading above its 200-day simple moving average
A simple moving average (SMA) is calculated by taking the sum of closing prices from the previous X number of days in a desired period and dividing it by that same number of days (arithmetic mean). You can use the moving average that best suits your investment time horizon. Here are a few examples:
- Short term: 20 days
- Medium term: 50 days
- Long term: 200 days
This indicator is used primarily to reveal trends. When a financial asset is trading above its moving average, it is said to be “bullish,” And when it is trading below, it is said to be “bearish.”
For example, the S&P 500 tends to perform better when it is trading above its 200-day SMA. sentimenTrader reports that since 1928, the index has traded above this indicator 67% of the time and during these periods, it achieved an average annualized return of +11.1%. When it traded below its 200-day SMA (33% of the time), its average annualized return was only +0.2%. In the same vein, active-trading experts Larry Connors and Cesar Alvarez observed when examining some eight million transactions completed between 1995 and 2007 that stocks with a long-term upward trend performed better over five days (+.025%) than those with a long-term downward trend (+0.18%). If you follow this principle, improving your success rate is within reach.
This rule of thumb can also help you manage risk more effectively. As you know, stock prices can collapse and, in some cases, even fall to zero. So, if you’re holding shares that drop below their 200-day SMA, selling them can help you avoid finding yourself up the creek without a paddle. That type of situation can cause quite a bit of anxiety, and worse, significant financial losses. For example, in March 2008, the financial services company JPMorgan Chase acquired investment firm Bear Stearns for the equivalent of $10 a share. What was Bear Sterns’s stock price when it dropped below its 200-day SMA, you ask? $150 a share!
In summary, we sometimes take shortcuts and rely on social proof to save time and energy, but that leads us to become dependent on others. So I encourage you to do your homework and put your faith in proven strategies and analysis tools, like the 200-day simple moving average. In addition, Desjardins Online Brokerage organizes hundreds of informational events every year to help you reach your goals. It’s time to stop following the crowd and forge your own path.Sources
- Larry Connors and Cesar Alvarez. Short Term Trading Strategies That Work, TradingMarkets, 2010.
- Robert Cialdini. Influence: The Psychology of Persuasion, Harper Business, 2006.