Understanding Relative Strength in Investing: A Guide to Outperform the Market

What Is Relative Strength?

Relative strength is an investment strategy used in momentum investing to identify securities that outperform the market or a chosen benchmark. By comparing the performance of an asset, such as a stock or sector, to an index like the S&P 500 or Nasdaq Composite, investors can target those demonstrating stronger upward momentum.

This approach can be applied across various markets and asset classes, helping investors focus on assets likely to continue outperforming. While relative strength strategies can offer potential rewards by capitalizing on market trends, they also carry risks if momentum shifts suddenly. Technical analysts often complement this strategy with the relative strength index (RSI), an indicator that flags overbought or oversold conditions to guide entry and exit points.

Analyzing the Role of Relative Strength in Investing

Value investing aims to buy low and sell high, while relative strength investing aims to buy high and sell higher. As such, relative strength investors assume that the trends currently displayed by the market will continue for long enough to allow them to realize a positive return. Any sudden reversal of that trend will lead to negative results.

To identify investment candidates, relative strength investors begin by observing a benchmark such as the Nasdaq Composite Index. They will then look to see which companies within that market have outperformed their peers, either by rising more rapidly than their peers or by falling less rapidly than them.

Because relative strength investing assumes that present trends will continue into the future, it is most effective in stable periods with minimal disruption. By contrast, chaotic periods such as the 2007–2008 financial crisis can be dangerous for relative strength investors because they can lead to sharp reversals of investment trends. In those situations, investor psychology can suddenly reverse, with yesterday's investment darlings suddenly being shunned.

Although momentum investing is often associated with individual stocks, it can also be applied to whole markets or industry sectors using index funds and exchange traded funds (ETFs). Investors can also use relative strength strategies in other asset classes, like real estate, using real estate investment trusts (REITs). More exotic instruments, such as commodity futures, options, and other derivative products, can also be used.

Practical Applications of Relative Strength: An Example

Harry is a relative strength investor who keeps a close eye on corporate bond prices and the S&P 500. His investment portfolio consists of an S&P 500 index fund and an ETF that tracks the corporate bond market. As a relative strength investor, he periodically increases his allocation toward whichever asset is outperforming at that time. In doing so, he hopes to benefit from the continuing trend of that asset's outperformance, effectively buying high and selling higher.

In recent months, he has noticed that investors seem to be increasing their portfolio bond allocations at the expense of stocks. This inflow of money into the bond market has been raising bond prices and lowering yields.

Expecting this trend to continue, Harry responds by decreasing his investment in the S&P 500 and increasing his investment in the corporate bond ETF. He hopes to benefit from any ongoing outperformance of bonds relative to stocks.

Understanding the Relative Strength Index (RSI) in Technical Analysis

Short-term and technical traders also consider relative strength. In technical analysis, the relative strength index (RSI) measures recent price changes to see if a stock is overbought or oversold. The RSI is displayed as an oscillator (a line graph that moves between two extremes) and can have a reading from 0 to 100. The indicator was originally developed by J. Welles Wilder Jr. and introduced in his seminal 1978 book, "New Concepts in Technical Trading Systems."

Traditional interpretation and usage of the RSI are that values of 70 or above indicate that a security is becoming overbought or overvalued and may be primed for a trend reversal or corrective pullback in price. An RSI reading of 30 or below indicates an oversold or undervalued condition.

The Bottom Line

Relative strength is a momentum investing strategy that focuses on buying securities that have outperformed the market or a benchmark, with the expectation that their upward trend will continue. Investors often use tools like the relative strength index (RSI) to identify overbought or oversold conditions to guide their trades.

While this approach can be applied to stocks, bonds, ETFs, and other asset classes, it carries risks, especially during sudden market reversals or periods of high volatility. Investors using relative strength should monitor market trends closely and be ready to adjust their positions to minimize potential losses.