Why relative strength?
Longboard Asset Management completed a study called The Capitalism Distribution that examined stock returns from the top 3000 stocks from 1983-2007. They found that:
-39% of stocks were unprofitable investments.
-19% of stocks lost at least 75% of their value.
-64% of stocks underperformed the index.
-25% of stocks were responsible for all the market’s gains.
Simply picking a stock out of a hat means you have a 64% chance of underperforming a basic index fund, and roughly a 40% chance of losing money!
Luckily, investors don’t need to picks stocks out of a hat and hope they get lucky in order to find the winners. Relative strength provides an effective framework for building a portfolio of winners and capitalizing on long term trends. Click here to read Relative Strength and Portfolio Management by John Lewis to see the results of relative strength tests on U.S. equities over a 16 year period. As summarized in the paper:
Relative strength and momentum strategies have delivered market-beating returns for many years. There has been a great deal of research in this area by both practitioners and academics. However, despite this public disclosure of information, these strategies continue to outperform over time. Many of the testing methodologies used over the years are not consistent with real-world portfolio construction and do not address the possible range of outcomes when implementing a relative strength strategy. Our continuous, Monte Carlo testing process corrects for both of these deficiencies. Similar to other research, our process shows simple relative strength factors to be extremely robust over intermediate horizon formation periods, and weak over very short-term and long-term horizons. We also find there can be great variation in portfolio returns over short time periods, but over long holding periods the portfolios perform exceptionally well.