Use 'relative strength' to your portfolio’s advantage

  • "Relative strength" represents measuring the performance of one security's price performance to another.
  • Many investors believe a lower-priced security or the one that has performed the worst over a given time will be the one to buy.
  • Creating a process to perform relative strength analysis can help show an investor which areas of the economy are performing and which are not good places to invest.
Stuart McClymont | Stone | Getty Images

If I told you I was a fast runner, that alone may not mean much. Relative to Usain Bolt, I'm probably pretty slow (I'll give him some credit for all those Olympic medals.) Compared to my youngest daughter, I am very fast in her eyes. Actually, she is very fast for her age, "relatively speaking."

This term can be a big help when seeking the right investments to purchase for your portfolio. Known as "relative strength," it represents measuring the performance of one security's price performance to another. On a chart, a line will show this ratio. If the line is moving up, the first security in the ratio is outperforming the second security of the ratio over the timeframe being viewed. By understanding how one investment has performed compared to another option you may be considering, you can often make a better-informed decision about which may be the right choice for your portfolio.

Why investment comparison matters

Many investors believe a lower-priced security or the one that has performed the worst over a given time will be the one to buy. Often it is viewed as cheaper or a good value. In my experience, that is not the best way to view making investments for a portfolio. That strategy of buying low often means selling lower and is based on hope.

Newton's Law suggests something will stay in motion until acted upon by another force. With investing, relative strength uses this theory and can potentially provide an advantage. The key is the need to watch when that force acts upon an investment and what you do with the investment when it does.

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The following example shows a relative strength comparison between the U.S. index (represented by the Dow Jones Industrial Average) and the international index (represented by the MSCI EAFE Index). The rising trend line drawn in green shows a generally increasing ratio over the past year. The arrow shows an area of a thrust higher over the recent period shown.

Source: StockCharts.com | Investopedia

This suggests that the U.S. market had been outperforming the international market on a relative basis over that year. There was a notable period from July into October in which this was not the case, but until the trend line is violated, we can say U.S. equities have been stronger.

How to view it

Creating a process to perform relative strength analysis can help show an investor which areas of the economy are performing and which are not good places to invest. The sectors in the lead often tell what part of the economic cycle we are in and what sectors may be strengthening and weakening in the near future.

Relative strength analysis can also determine which asset classes would be appropriate for a tactical overweight or underweight decision. If equities are performing well, is large cap the place to be? Or would mid or small cap equities be doing better relative to blue-chip stocks? How do international or emerging markets compare to U.S. equities?

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If considering specific securities, is a Home Depot versus a Lowes comparison necessary in order to see which has the advantage of better relative strength? A simple chart comparison can go a long way toward improving investment decisions.

(Editor's Note: This column originally appeared at Investopedia.com.)

— By Steve Economopoulos, chief investment strategist and managing partner, Econ Wealth Management

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