Investing Can Be Your Fast Road to Retirement Riches
The following chapter is extracted from my book, Super Investing: 5 Proven Methods for Beating the Market and Retiring Rich. As a Wall Street professional, my job was to research and then create tested profitable investing and trading systems for stocks, bonds, currencies, gold and commodities. Having spent years testing every type of conceivable system, I discovered only a few will make you rich in the long run. This book is all about those proven methods, and the lessons I would teach teenagers and college students to set them on the path to being able to retire rich through investing. I was always fascinated by the goal of creating a means for creating generational wealth, and in this book I lay out all the proven methods you can use to fund that objective.
 
One of the most insightful books for creating investing systems is a little known classic, The Hedge Fund Edge, written by Mark Boucher. Within this book Boucher tells the story of how he met a very low key private European money manager, with failing health, who after many years in the investment business decided to teach Mark his highly secretive method for managing billions in client funds for extremely high returns.
The track record of this secret methodology should grab your attention, as should its basic set of rules since it was said to have worked for well over three decades. Few investing methods work consistently over long periods of time, and when they do it is usually because they have captured some sort of fundamentally sound approach to market investing. You won’t have all the tools readily available to exactly duplicate this technique, but the lessons are so valuable that you will be able to immediately apply what you learn elsewhere to great advantage.
This highly secretive European manager reported extremely impressive returns with very low risk. His long term compound annual growth rate (CAGR) for managing funds was greater than 19% per year since the mid-1950’s, and that’s without ever having had a drawdown greater than 20% on the money he managed. Furthermore, in over thirty years of managing money he had only seen one negative calendar year on his investments (-5% in 1974)!
These are incredible results. Mutual funds would literally break down the doors with offers to hire anyone who could duplicate such returns. If you started with $100,000 and compounded your performance at 19% per year over thirty years, you’d be left with over $18 million before taxes. Clearly this is a method for creating generational wealth, and the return doesn’t even factor in the possibility of adding funds along the way for greater wealth accumulation.
This is the type of performance that can build a financial dynasty if it is kept up over time while avoiding taxes, and the methodology he used to capture these returns was both extremely simple and extremely logical. When you remember that the large financial fortunes could only grow their own funds at a long run rate of return of around 7-8% over the generations, this is the type of method we want to use to grow our wealth over many years if we desire an active form of diversified investing.
So how does it work?
The method concentrates on monitoring all the stock markets in the world and buying those that are currently advancing better than all others (as determined by a relative ranking), but only getting into those investments if there seems to be a fundamental basis supporting those advancing moves. You buy the world’s best performing stock markets by rotating into a country’s market when it starts outperforming everything else, and you get out of these investments when they fall out of the top tier of outperformers. Additionally, the basic rules of diversification and money management are also applied to protect the total portfolio from excessive risks and drawdowns.
In a sense, these rules are similar to those commonly used by commodity and foreign currency fund managers. These investment businesses typically use a trend following approach to manage billions in positions, and those methods make buy and sell decisions based on market price movements alone. These trend following models never stipulate that a price trend has to have a strong fundamental basis behind it and yet for many markets, just making trades based purely on the trending pattern of price movements can produce substantial profits. The trick is that you must trade enough markets together and then you can capture some big movements from within this pack.
The weakness of a pure trend following approach to investing is that when you trade on just price movements by themselves, without insisting that you verify there are fundamental reasons behind those moves, it opens you up to tremendous price gyrations and sharp reversals. Prices will often suddenly go against you, and then you must get out of your positions because your trend following systems will trigger a signal to exit the market (“go neutral” to a “risk off” condition) or reverse positions (go from long to short or short to long). Without a fundamental basis behind your investing, but just buying or selling based on the shape of price movements alone, you never really know if you are investing in a true long term trend. You are always subject to rapid whipsaw losses whenever you reverse your position, and you never know if it would be better to hold a position through extreme market volatility instead.
When I was in the business of creating computer rules to manage such funds, the way we avoided significant portfolio drawdowns (and catastrophic losses) was by diversifying ourselves into many different assets and by using many trading models. We would hold many positions in many different markets, most of which were uncorrelated to each other, and furthered our diversification by using multiple models to trade each single market. We also always used adaptive money management principles that continually adjusted the risks of our positions, and every rule for entering a market had a well defined rule for when we should leave that position. In other words, there was always a clearly defined exit strategy for each and every market position. These computerized rules not only helped us manage our risks but entirely eliminated emotions from the process of investing.
In commodities fund management, you are always trying to capture the short term, intermediate term and long term trends of the various markets you are in, and you want to layer the profits from various positions together. Sometimes you can capture gigantic upward or downward trends that last years, and sometimes a trend you thought had just started disappears almost immediately as soon as you enter the trade. Quite often with this type of trading you could accrue a sizeable chunk of unrealized profits from a steady trend that took months to unfold, but those “virtual” profits could disappear overnight due to a single adverse price swing. All you needed was a large price movement in the opposite direction suddenly appearing out of nowhere. The gold and silver markets, for instance, were famous for extreme one day moves that suddenly took away profits earned over many months, which is the same case today because those markets are very heavily manipulated.
As long as you had good asset allocation rules that prevented you from putting all your trading bets in one basket, and practiced prudent money management skills that had you adaptively managing risks, then when a big winner came along (or when multiple markets started making moves) you could usually capture a substantial portion of those profits and over-deliver in terms of portfolio performance. Big moves meant big profits, whereas small moves and choppy markets meant losses.
As mentioned, one of the keys to our long term profits was to follow automatic trading rules that determined clearly defined entry and exit points for all positions, and which eliminated all emotions from trading. While timing models and trading rules were important, a great deal of our outperformance came from applying very strict money management rules. In particular, our performance was greatly determined by asset allocation rules that put us into the big market movers for the year. Good money management and asset allocation rules, rather than buy and sell systems, almost always dominated the performance of our portfolios, and I find this principle to be true with most every fund manager I have looked at. You live or die based on the excellence of your money management systems.
Speaking frankly, when there is a big trend then most every decent trend following system will make money for you if you are a trend follower. Since you cannot predict the performance of individual trend following systems, you cannot anticipate which system will be the most profitable for you in a market, but if there is a strong trend they will all tend to make money. It is the large strong trends that make you most of your money in a year. Therefore, being in the right market is usually the most important thing to making the big money because you could have 97 markets that did nothing significant in terms of price movements all year long, and 3 markets that made large moves no one could even imagine! Having more money allocated to the 3 markets which made the big moves of the year would definitely separate you from all the other fund managers who were also using trend following rules, too, so your asset allocation had a bigger effect on your overall performance than the actual rules you used for trading. Generally speaking, how you manage your portfolio through your asset allocation and money management rules will have a bigger impact on your total profits than the accuracy of your individual trading systems, especially when you use several systems bundled together to trade separate markets.
If you have a large allocation to gold or oil in your portfolio and either makes a big bull run that year, you will usually have a fantastically profitable year compared to funds that gave them just a mild weighting in their portfolios. The same goes for stock portfolios that heavily invest in the best moving stock sectors of the year. That’s the power of superior asset allocation. It always pays to be in the biggest movers with the strongest trend strength, but the question is how to determine which ones will be best that year. You cannot put all your bets on just one asset because if that market suddenly turns you could lose a significant portion of your funds. The best strategy is to have significant positions in the best performing markets, but you also want the diversification of having many other positions, too.
The investing approach of Boucher’s elderly European friend had similarities to all this in that it basically used a version of “momentum investing,” or relative strength investing, to secure positions in the strongest moving world stock market leaders. In momentum investing you are looking for an asset that is already strongly increasing or declining in price, and then you enter a trade that rides the coattails of that trend in hopes that the move will continue. The assumption is that any market movement will have continuing momentum or inertia that pushes it in the same direction, and you want to capture a good portion of those profits if you can. In short, you are basically hoping that a market surge, once identified, will persist long enough for you to make money by the time you get out. You cannot capture all the profits of a trend from low to high, but if you can capture just 30-50% of the trend, and do this over and over again, you can end up looking like a genius. Baron von Rothschild is famous for saying, “You can have the first 30% and the last 30% of any move, just give me the safe 40% in the middle,” which captures this idea precisely.
The problem with momentum investing, which is betting on a trend to continue, is that it doesn’t always continue. You might get in too late and you might get out too early. You must also often eat lots of little whipsaw losses, too, which are short trends caused by temporary volatility spikes that never turn into big moves. You must also try to keep as much of the profits you make from big trends as possible, rather than always lose them through sudden trend reversals that might take away most of your gains. In the aforementioned gold market, it was typical to slowly accumulate profits for months and then see them all suddenly erased in a single day when gold made a spikey move in the opposite direction.
Many markets are extremely volatile like this, especially with today’s large price swings triggered by automatic trading robots. These sudden moves can kill an investor who overtrades with too much leverage, and who is not risk balanced with a number of diversified positions that helps dampen volatility. When these sudden moves happen, it’s hard to tell anymore if a price drop is due to deteriorating fundamentals or just artificial market manipulations. You need clear exit rules to get you out of positions under both circumstances otherwise you face the potential of catastrophic losses.
For instance, one of my best friends, an experienced investor, had all his retirement funds invested in Citibank stock which had climbed in price for many years to make him a millionaire several times over. Without an exit rule, however, he just could not pull the trigger to get out of his Citibank holdings as the stock continued to decline throughout 2007 and 2008. After every drop he would say to himself that his long term winner was sure to go up again, so he kept holding onto his position. After all, how could Citibank possibly go bankrupt? Every time he got ready to bite the bullet and sell some shares, Citibank’s stock price would suddenly collapse causing yet another round of waiting in hopes he might liquidate at a better price. He eventually lost 95% of his savings when Citibank, previously a $55 stock, fell to its floor and entered penny stock territory at $3-4 a share.
If a market advances slowly through a solid trend, as in this case study, you can make money on that trend as long as you exit before prices suddenly collapse and eliminate all the accumulated profits. “What the market giveth slowly, it quickly taketh away.” When a particular market moves just a little, then you probably won’t make any money at all on that investment and it would simply have been better to put those funds in some other investment that was moving more strongly. Momentum investors always try to put their money in the strongest trends, but they use explicit rules to define those trends and their entry and exit decisions.
The best type of momentum investing tries to sort out which trends are not flukes, but genuine movements with strong fundamentals that are therefore likely to continue. You don’t have to get in at the bottom or out at the top of a big price trend to make substantial money. You do not have to pick tops or bottoms. All you must do is just capture a great enough portion of a trend to make money. Most of the time you cannot capture even 50% of a stock trend, and yet you can still do extremely well capturing a small fraction if the move is large enough. The key is to make money without risking too much and by minimizing losses when you are wrong. Since you can never predict how much you will make from the markets, you try to make as much as the market will give you (without risking too much) and minimize losses when they occur.
When will a moving asset stop moving in the same direction? It will keep moving until it stops moving. That’s all we can say. Nonetheless, people use all sorts of methods to try to forecast the end of market movements. There are technical methods like cycles analysis, Elliott Wave analysis, and even seasonal analysis, but no method is consistently reliable. In short, no one ever knows for sure which market will be the biggest mover of the year, and when a trend will definitively start or end. A market could stay in the doldrums for years, or keep marching upwards well past anyone’s expectations.
To get around this problem of the frequent uselessness of forecasting, in momentum investing you simply get into an investment after you identify that prices are making a trend and then hold that investment until some rule determines that the trend has significantly changed. Between getting in and getting out of the investment, you hope the trend continues long enough that you can make some exceptional money. Whenever the trend moves against you, you also must have rules to manage (adjust) your risks and profits so that they don’t all suddenly disappear.
In this case, our European money manager never entered into investments simply because they demonstrated upward price action. Before investing in some foreign stock market, he always insisted that there was some fundamental reason behind its upward advance and for stock market fundamentals he focused on interest rates. Because he was investing in stocks, seeking that fundamental reason meant that he was always looking to see that there was a favorable interest rate environment to support the bullish trend. The underlying monetary conditions served as his confirmation indicator!
As we have already seen in discussing market timing models, over the long run the interest rate models are among the best you can use to tell if the stock market environment is fundamentally bullish or bearish. You can come up with sentiment models, economic models, valuation models and all sorts of other models to help time the market indices. However, except during periods of financial extremes called “end games,” interest rate monetary models tend to best decipher the underlying fundamental forces moving stock markets and separate conditions into bullish and bearish environments. Hence, seeking a fundamental reason behind a stock market advancing trend, the interest rate explanation is what our expert European money manager chose to rely upon.
If a country’s stock market was performing well—meaning it was above its 40-week moving average—this money manager assumed that it would continue to do so as long as there were fundamental reasons behind the advance. Thus, he was looking to invest in world stock markets that were already moving up and which also had a favorable interest rate environment, which he monitored by looking at a 40-week moving average of the bond and treasury bill (short rate) prices for each market. If a country’s stock and bond markets did not have these two characteristics, he didn’t even consider it as a possibility for his investments.
As with our earlier interest rate model, any time a country’s stock index fell below its 40-week moving average, it was eliminated from his consideration. Anytime the bond and bill (short rate) prices for a country both fell below their 40-week moving average, he also eliminated the market from consideration as an investment. Both the market trend and interest rate trends had to be favorable to consider something a possible investment. This highly secretive manager combined these basic rules in the following model which he then used to achieve his exceptional returns.
THE RULES:
First, he kept a 6-month relative strength table of world stock market indices that compared as many global markets as possible. He also produced a 6-month relative strength table of world interest rate trends, too. If some country’s stock market was trading above its 40-week moving average then its trend was considered bullish, and bearish otherwise. This trending signal helped insure that prices were moving in the right direction. He only looked at rising markets to construct his table.
As to this world interest rate table, he created a 6-month world relative strength table for all 10-year bond markets and all 90-day short rate prices, and then averaged the two indices together for each country to come up with one final composite number. If 10-year bond prices were going up for a country (if they were greater than their 40-week moving average) it was considered bullish because it meant interest rates were falling. If short term interest rates were falling (if they were less than their 40-week moving average) it was considered bullish as well.
After constructing a relative strength table for all the world’s stock markets and interest rate markets, he only considered investing in markets where both the stock trend and the interest rate trend were favorable. He was basically sorting all the world’s markets into an “A” pile and “B” pile. The “A” pile contained stock markets that were already going up where the interest rate environment was also favorable. The “B” pile contained markets where this wasn’t happening, and so you wouldn’t even consider those markets for investment. You were going to invest in the “A” pile candidates and avoid the “B” pile markets because an upwards trend wasn’t there or the monetary environment (interest rate) fundamentals weren’t there. Thus, your asset allocation strategy was to invest only in some subset of the markets currently advancing that also had strong fundamentals. You also avoided the “B” pile candidates which represented the potentially negative consequences which Warren Buffett would denote as representing “catastrophic risk.”
By looking at this table that evaluated as many world markets as possible, this European manager could compare all possible markets at one glance to see who was doing better or worse than everyone else, and then position himself in several of the top markets. By always investing in the top tier of favorable stock markets, he was hedging his risks by practicing international diversification. By investing internationally, this also gave him the chance to outperform everyone else who was just limited to investing in their home nation.
You can immediately realize that the idea of international diversification would allow him to find some country in the world where the stock market was moving up when others might be declining. This methodology capitalizes on your ability to put your money in widely different markets. As the story of my Nicaraguan college classmate illustrated, this ability to move your assets to other countries is sometimes essential to preserving your wealth rather than just increase it.
Remember that this money manager was not only looking for a positive momentum trend in each foreign stock market, but was looking for confirmation of a favorable monetary environment in that country by referencing the interest rate trends – his “fundamentals.” Thus this method taps into my professed preference for combining technical and fundamental information together. Once he had the two relative strength indices, he then combined the stock market and interest rate relative strength index into a single index for each country, ranked them all in order from highest to lowest, and only considered investments in markets at the top of the list. Those were the markets already doing better than everyone else in terms of price movements and interest rate fundamentals.
With his massive relative strength table finished, now came the time for asset allocation. This manager simply took the top five markets from this list and put 20% of his money in each of those markets. If there were only four countries on the list, 25% of his investment funds would be allocated to each market equally. If there were only three countries on the list, 25% would go into each of the three markets, and 25% into T-bills or money markets to collect interest. If there were only two countries on the list, 25% would go into each of those two markets, and 50% would go into T-bills or money market funds. If there was only one country on the list, it would get 25% of his funds, and 75% would be put into T-bills or money markets.
If there were no countries with an advancing stock market and favorable interest rate environment, this ultra-successful money manager would simply park the funds in T-bills to collect interest until one or more advancing markets showed up. He put his money in cash, and this allowed him to sidestep large drawdowns during bear markets, which were usually accompanied by the unfavorable interest rate trends that his model had aptly captured. He never tried to get a quick gain in a market, but simply said that if the conditions were not right or the opportunities were not promising, he simply wouldn’t invest in a country’s stock market. Whatever the market would return him, after allocating his money to the strongest investments, that’s what he would earn.
Every six months, on January 1 and July 1, he would then rebalance his portfolio to include the new top-ranking countries from his table. If he found that a country had dropped off from his combo relative strength table list, he would simply re-allocate those funds to another country that was now in the top tier rankings. Which country? To one that had the highest rank of any he wasn’t already invested in.
These were his basic investing rules, and with the computational power of modern computers that is now available, there are lots of ways someone could try to improve on these results after doing some intensive research. He basically followed this simple plan with persistence and in time he achieved an extraordinary rate of return that harkens of Warren Buffett. The method was opportunistic in that it identified the best opportunities in the world and pursued them to the exclusion of all others, banking on the persistence of momentum when there was a fundamental support for the bullish move. He also diversified himself through asset allocation so that he was always protecting himself by hedging his bets.
Most momentum investors are usually perplexed as to when they should exit a market, but the periodic re-evaluation and then rebalancing of his portfolio made sure this happened automatically. Study after study shows that rebalancing a portfolio usually increases returns and reduces risk, but it requires discipline to do this. Rebalancing is equivalent to taking some profit off the table when a market has moved much higher, and re-allocating those funds to assets not performing as well. It forces you to take profits on a portion of your position.
In the commodity fund management arena, many funds are also designed to do automatic rebalancing, too. Many fund managers liquidate positions to harvest some profits when market volatility increases, and this procedure tends to reap far more gains than simply holding long term positions until their trends turn. The fact that you secure some degree of definite profits—by cashing out a portion of a strong position after extreme price moves send the volatility skyrocketing—ends up making you more money than if you are simply a pure trend following investor. Even William O’Neil who studied the largest market winners of all time, and famous stock trader Dan Zanger, both said that you should consider selling 20-30% of any new position when a stock moved up 15-20% from a breakout point because you never knew if the trend would falter and turn down again. Thus, the regular rebalancing of your portfolio from such enforced selling becomes an essential element of incredible outperformance and long-term investment success.
While the 6-month rebalancing period for this methodology might not be optimal, only testing can determine what rebalancing period would perform best. A 4-month or 3-month rebalancing period might be even better, but you’d have to perform extensive computer simulations to find out. The longer the holding period without rebalancing, the more you are exposed to risks that rebalancing normally helps to eliminate. Then again, the longer you hold a position, the less likely you will be prematurely thrown out of a truly advancing market because of temporary volatility. In any case, this manager also had a number of other strategies that also helped him cut potential losses, boost his performance, and achieve consistent results with very low risks.
There are lots of different ways to possibly improve upon this basic technique, and now that you know the general methodology, you might end up using some form of this strategy in the management of your own funds. For instance, S&P analyst Sam Stovall came up with his own version of this basic relative strength methodology which you can find in The Seven Rules of Wall Street. He would invest in the top ten industries that exhibited the strongest trailing 12-month price performances. He would rebalance his holdings at the end of every month, removing those which fell out of the top ten, and then buy the new candidates that came into the top tier. Over the last twenty years you would be swapping three industries per month on average, which is a lot of turnover but quite doable. There are lots of things researchers can test that might improve upon the basic method, and many principles revealed in this example about how to achieve both consistent and magnificent multi-year returns by internationally investing in world stock markets.
First, you want to follow a large number of potential investment vehicles, which in this example were the international stock markets. Today you might also add many more country, industry sector, commodity and currency ETFs as well as various no load mutual funds to your list of investment candidates. Having a larger list of investment options increases your chances of finding bull markets (or bear markets) to invest in, and the more markets you consider helps with the task of minimizing risks and diversifying your positions. Next, you want to produce a mega-list of all these candidates ordered by their relative strength and fundamentals.
It is easy to rank markets in order of their relative strength to determine the runaway markets moving the fastest at any point in time. Thus it is very easy to determine who is currently strongest in terms of current price movements. You can go to a website such as ETFscreen.com and do this immediately. The problem lies in figuring out which relative strength leaders have any fundamental power behind them because it is always fundamental “fuel” of some type that helps to insure a trend’s strength and reliability for continual advancement.
In stocks, traders often try to get at this idea of fundamental fuel by determining if the volume is increasing in the direction of the trend, or if company insiders are buying shares. Some Wall Street houses go so far as to build complicated models for each stock, market segment or sector to estimate their bullish potential. Others screen stocks for various criteria to see if there are various fundamentals behind a breakout, such as quarterly sales accelerating at a pace of 40% or more, a return on equity of 17% or more, annual earnings up 18-20% or more, and continual quarter-over-quarter sequential expansions of company earnings and revenues. These are all examples of screening criteria that look for potentially explosive stock situations.
Rather than just getting into a stock, market index, ETF or other asset because the price is going up, you must remember this rule that there must always be some type of fundamental fuel, or fundamental causation, behind the market advance for you to safely get into that investment vehicle. Otherwise, you open yourself up to the potential of losing all your money by investing in some type of empty bubble. The Dubai real estate property bubble, the internet stock bubble, and various short lived collectible trends are a few examples that come to mind of upward price moves that had little fundamental strength behind them.
Our European manager looked for his fundamental support by referencing interest rate trends in every country he considered, and this determined the safest and most profitable periods for investing in those countries. He always wanted to be in stock markets when yields were falling for as we have seen, lower interest rates typically power strong stock market advances. In any case, whatever you choose to rely upon as your fundamental reason to invest, you must make sure it truly indicates that there is substantial, growing buying power behind an advance.
In individual stock trading, we already know that earnings increases and increasing trading volume are two types of reliable indicators which suggest some lasting power behind advancing stock prices. However, another indicator for trusting superior relative strength is that there are also other leading stocks in the same industry group demonstrating similar strong performance as well, which then suggests that the advance is an industry issue. A stock’s price momentum is usually driven by the performance of its industry or sector rather than by the particulars of the stock, so when multiple stocks in a sector also outperform, this suggests that the trend is more reliable. However, this does not identify the actual fundamental fuel behind the advance. The big principle to understand is that you always need to insure there are valuations or fundamentals behind leading price movements and surging relative strength when using this particular momentum investment technique.
If you can restrict your investments in only the top performing (high relative strength) markets that have growing fundamental support, this is wisely concentrating your money where the top opportunities lie. Many of those investments will often turn into runaway markets that are likely to keep progressing into the far future. If you use asset allocation and money management rules on top of this to further diversify your risks, and periodically rebalance your portfolio to keep the monies concentrated in the best performers (and away from losers), you have the basics of an outperforming investing technique. These are the basic ideas behind this 19% per year system.
Quite a few researchers, including Ned Davis Research and AQR Capital, have found that simply partitioning stocks into large quintile, quartile or decile groupings based on relative strength rankings consistently differentiated the best performing from the worst performing stocks of the year. In other words, relative strength rankings definitely differentiate the best from worst stocks! This partitioning of stocks into a sliding scale of high to low relative strength rankings has become a staple of the investment community, and the idea has been incorporated in the famous Value Line rankings, IBD (Investor’s Business Daily) rankings, and VectorVest rankings, among others. When you use ten deciles for ranking purposes, the higher relative strength groupings have always performed better than the lower in consecutive series; the top decile performs better than the second best, which performs better than the third best and so on. That’s what you want to see if there is truly some fundamental relationship behind some particular investment technique.
Many research studies have shown that buying the top tier of stocks with the strongest relative strength rankings, and then selling those stocks when their rankings fell far enough, would greatly outperform the market. There are studies showing that portfolios that give their greatest exposure to high momentum stocks significantly outperform those with the lowest levels. When momentum (relative strength) is combined with stock valuation, the results are particularly beneficial because the two strategies are negatively correlated. When value stocks, for instance, have been long term losers but then move into high relative strength territory, they usually go on to outperform in spades. We will later see that this was one of the factors to the Walter Schloss value investing system.
Some relative strength research going all the way back to the 1920’s (Mebane Faber) has shown that buying the top performing stocks can outperform the buy and hold benchmark in 70% of all years, and simple adjustments to the basic idea can improve drawdowns and volatility dramatically. Other research (Tom Hancock) has shown that a momentum stock selection strategy outperformed a broader market average by nearly 4% per year from 1927 to 2009, which is an incredible difference since it is both significantly large and consistent. James O’Shaughnessy found that using relative strength as a criteria for stock portfolios added an extra return of 4% per year as well. Another study using rolling 10-year time horizons, starting in 1940, showed that relative strength investing outperformed buy and hold portfolios in 100% of the time periods. From yet other studies we also know that these relative strength outperformance results hold when applied to various other asset classes, sectors, and international stock markets, but rarely for short time horizons. Strong relative strength performance can continue over weeks or even months due to inertia, so the most common profitable strategy has been to hold assets ranked highest by their relative strength and hold them until their ranking falls to some pre-determined level.
Another big lesson you should derive from this, besides the idea that relative strength rankings identify which markets are probably the best movers of the year that will possibly continue to outperform (so that relative performance often leads to absolute performance), is the idea of international asset diversification once again. If your worldview is consumed solely by U.S. equities, you dramatically cut your potential for superior returns. This technique and the experience of history both strongly suggest that you should always broaden your investment horizons to include international assets. “It’s hard to set up different brokerage accounts to do international investing” is no longer an excuse to international diversification because the availability of ETF funds for all sorts of markets, asset classes and sectors now allows you to tap into foreign markets with ease.
Remember that relative strength, or momentum investing, is not a contrarian or value investment strategy that identifies an undervalued asset, takes a position and then sometimes waits years for it to go up in value. Relative strength ranking systems lock onto the correct side of the major leadership trends that are already moving. They are momentum-based strategies that are always invested in the best movers. What they are usually missing is the extra requirement that those asset movements are strongly supported by fundamentals, and yet even without that condition the various studies consistently show that this methodology still works wonderfully. Our European money manager’s extra requirement for strong supporting interest rate fundamentals separates his methodology from a simplistic relative strength strategy of always investing in the market leaders until they fall out of the top leadership tier, and with these extra precautions this strategy is still an outperformer. You should therefore always look for a fundamental reason behind an advance, if you have a means to do so, because it helps put the odds in your favor that the trend is safe, reliable and will continue.
In The Hedge Fund Edge, Boucher stated that he performed extensive research on this basic system to determine various ways to make it better, and I’m sure you can see there are many things you might want to test. Today you can monitor the relative strength of many markets using websites like ETFscreen.com that indicate who’s performing best at any moment in time. It’s only the interest rate information backing each stock market that is difficult to find and match with the relative strength numbers so that you can easily duplicate the technique. However, on individual stocks the proxy for interest rate relative strength might be earnings relative strength, and that information is available from sources such as IBD which also publishes industry relative strength figures.
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