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Retirement Plan Investing
Relative Strength Investing
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Also known as momentum investing, relative strength is the tendency of investments to exhibit persistence in their relative performance. In other words, investments that have performed relatively well will continue to do so, and vice versa. Relative strength investing is a disciplined, systematic investing style that can be applied across asset classes as well as individual securities. Although historically it has been difficult for individual investors to capitalize on this effect due to transaction costs and tax concerns, relative strength strategies are becoming more commonplace and accessible.
The Evidence
Momentum investing delivers positive abnormal returns, also known as alpha, above the market returns (Jegadeesh and Titman 1993; Asness 1994; Fama and French 1996, 2008; Moskowitz and Grinblatt 1999). Its effect exists not only in individual securities, but also across and within asset classes, such as small, mid and large cap stocks and value and growth stocks. There is also evidence of momentum in international stocks, fixed income and currencies. Being negatively correlated to the value effect (value stocks tend to outperform growth stocks due their increased inherent risks), the combination of momentum with value lowers risk and improves portfolio efficiency.
Possible Explanations
There are many possible explanations as to why relative strength and momentum investing leads to alpha generation. One explanation is that investors are slow to react to new information, treating it as an anomaly and requiring further data for confirmation. Another explanation is through the way human beings are susceptible to what psychologists call the "disposition effect". This effect describes the tendency of investors to sell investments prematurely to lock in gains and hold onto losing investments too long in order to break even. "Window dressing" by fund managers may also contribute to the momentum effect. They may tend to buy securities that have outperformed in an effort to appear to have held the best performing securities. Similarly, fund managers that have held the best performers will see the most asset inflows, which will result in them recycling those flows back into their favorite stocks.
The precise rationale is still unknown, but it is widely accepted that relative strength and momentum investing provides abnormal positive returns across and within multiple asset classes.