Overview
Relative strength is a momentum-focused investment approach that seeks to buy assets that have been outperforming a chosen benchmark and to avoid (or short) assets that have been underperforming. Rather than seeking bargains by buying the cheapest stocks, relative-strength investors attempt to “buy high and sell higher” by riding trends. The approach can be applied to single stocks, sectors, asset classes (stocks vs. bonds), and to funds/ETFs.
Sources and background
– Investopedia, “Relative Strength”
– J. Welles Wilder Jr., New Concepts in Technical Trading Systems (1978) — origin of the Relative Strength Index (RSI)
– Academic momentum literature: Jegadeesh & Titman (1993), Carhart (1997) — evidence that momentum has historically produced returns (but also suffers occasional large drawdowns)
Key ideas (at a glance)
– Relative strength = performance of an asset relative to a benchmark or peer group.
– Momentum assumption: recent winners tend to continue to win (at least for some holding period).
– Relative Strength Index (RSI) is a technical indicator related to momentum that signals overbought (>70) and oversold (1 year to qualify for long-term gains where beneficial, or use tax-loss harvesting).
8. Monitor and iterate
• Track performance vs benchmark and stress-test under different regimes. Backtest before live deployment. Consider walk-forward tests to avoid lookahead bias.
Part B — Asset-allocation relative strength (rotating between asset classes)
1. Choose broad asset classes (e.g., equities, bonds, commodities, cash/short-term treasuries).
2. Use a lookback (e.g., 3–12 months) to compute relative returns vs a cash or total-portfolio benchmark.
3. Allocate more capital to the asset class(es) with the highest relative strength (e.g., overweight top 1–2 assets, or spread allocation among the top 3).
4. Rebalance monthly or quarterly. Apply risk parity / volatility scaling if desired.
5. Maintain cash or safe asset allocation when no asset class shows positive relative strength.
Using RSI as a timing overlay
– RSI basics: RSI = 100 − [100 / (1 + RS)], RS = avg gain / avg loss over N periods (typical N = 14).
– Typical thresholds: RSI > 70 (overbought — possible pullback), RSI 0 or price > 200-day MA) before allocating.
– Volatility-scaling: weight positions inversely to their volatility to manage risk contribution.
Practical tips and rules of thumb
– Use longer lookbacks (6–12 months) for cross-sectional momentum to capture persistent trends.
– Avoid over-trading — higher turnover can negate benefits.
– Combine momentum signals with risk controls and diversification.
– Be prepared for intermittent severe drawdowns; maintain a written plan for when to cut positions.
– For retail investors, ETFs can implement relative strength across sectors/asset classes with lower trading cost and easier diversification.
When relative strength tends to work best
– Trending markets with low macro disruption.
– Periods where market leadership shifts gradually rather than abruptly.
– Across liquid, diversified universes where turnover and capacity are manageable.
When to be cautious
– Market crises, sudden regime shifts, liquidity squeezes, or rapid sentiment reversals — relative strength can lead to large losses if trends reverse quickly.
– Highly concentrated strategies can amplify sector-specific shocks.
Further reading and references
– Investopedia, “Relative Strength” (source page provided)
– Wilder, J. Welles, New Concepts in Technical Trading Systems (1978) — RSI origin
– Jegadeesh, N., & Titman, S. (1993). Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency. Journal of Finance.
– Carhart, M. M. (1997). On Persistence in Mutual Fund Performance. Journal of Finance.
Checklist — Quick setup for a first live test
1. Choose universe (e.g., S&P 500).
2. Choose lookback (start with 6–12 months).
3. Compute relative returns and rank.
4. Pick top 20 names; equal-weight them.
5. Rebalance every 3 months.
6. Cap position sizes and sector exposures.
7. Backtest, include costs, run live paper-trade for 6 months before full deployment.
Conclusion
Relative strength is a versatile, systematic approach to capturing momentum across securities, sectors, or asset classes. It can be implemented at many frequencies and with many risk controls, but it requires careful selection of lookbacks, awareness of transaction costs and taxes, and preparation for periods of sharp reversals. Use backtesting and risk controls; consider combining relative strength with other factors (value, quality) for a more robust long-term strategy.
Editor’s note: The following topics are reserved for upcoming updates and will be expanded with detailed examples and datasets.