Our friends at Dorsey Wright and Associates have always maintained that, “It’s often about what you don’t own”, when it comes to returns. Successful investing relies on your ability to select favorable investments, but it also hinges on avoiding poor ones. Relative strength helps us to achieve this.
Relative strength measures the performance of one investment vs. another. We can calculate relative strength for stocks, ETFs, sectors, mutual funds, asset classes and more. It shows us what areas of the market to overweight and what areas to underweight.
Market sectors rotate in and out of season just like produce in the super market. Take a look at the chart below for an outstanding embodiment of that concept. You can enlarge the picture by clicking it.
What’s most troublesome are the worst performing sectors. A look across the chart’s bottom row gives a good idea of why it’s often about what you don’t own.
The impact that negative numbers can have on compounding returns is staggering, and often misunderstood by investors. For example, losing 20% on an investment will require not a 20% gain to be offset, but a 25% gain. Consistently having exposure to the worst performing sectors of the market can put you in a hole quickly.
This is why we allow relative strength to guide our investment process at Mullooly Asset Management. Overweighting sectors that have superior relative strength, while steering clear of those with poor relative strength helps us to avoid negative numbers and stay on the right side of market trends.