The Rationale for Moving Averages

from dshort.com
By guest contributor Tom Forest
January 30, 2009

Compared to Buy and Hold strategies, investing with a Simple Moving Average (SMA) system improves returns because of the effect of serial correlation in SMA signals.

Serially correlated signals are those where the value in one time interval is predicative of the value in the subsequent interval. For example, in a 10-month SMA strategy, if the one-month average is greater than the 10-month SMA (let's label this state +), then next month the one-month average is also likely to be greater than the 10-month SMA (+). Similarly, if the one-month average is less than the 10-month SMA (-), then next month the signal is also likely to be (-). In an SMA system, we don't know when the series will change from + to -, or - to +, but the system works because + months are more likely than average to be followed by + months, and - months by - months.