Sunday, April 3, 2011

Smarter Investing in Any Economy The Definitive Guide to Relative Strength Investing Review

One of the etf investing strategies I am currently using is Relative Strength. Basically relative strength investing invests in the strongest performing etfs or stocks. The idea is that those sectors that have been performing the strongest in the past will continue to perform strong in the current year.

The book Smarter Investing in Any Economy The Definitive Guide to Relative Strength Investing,  by Michael Carr,is a comprehensive study of this method with thorough back testing and results to support it. If you are interested in this subject, this book is a must read. 

The book begins by discussing why relative strength investing works. People tend to pile into markets that have performed well creating trends. Carr provides many references to studies on trend following and the results which support relative strength investing.

Carr then proceeds to explore and test 9 methods in detail for calculating relative strength. Carr gives the formulas and back testing results for each method. This research alone would be worth the price of the book since back testing relative strength strategies is very difficult to do. All 9 methods for calculating relative strength out performed the S&P 500 which supports the robustness of this strategy. 

Carr then selects the strategy he felt had the best risk reward. He works on optimizing this strategy, but is very careful and aware of data mining and over optimization. You can be confident his optimization work is reliable as his results provide a wide range of profitability and selecting a range of inputs will still beat the S&P 500. 

One of the qualities that sets this book apart from most is the risk analysis, and the extra steps Carr takes to reduce risk in the relative strength method. The problem with relative strength investing is that, though it out performs when the market is going well, it can decline much steeper than the overall market when it begins to fail. You can give back all of your precious gains very quickly if you do not have risk management in your system. The method will rotate you out of the under performing sectors but without risk management you can suffer significant draw downs in a relative strength strategy. Carr advocates the uses of trailing stops which do reduce profits, but they reduce draw downs. Another area of risk reduction is diversity by using etfs, and a balance of asset classes. He provides 3 sets of etf groups and runs the strategy on these 3 etf groups which helps reduce the overall risk. He also uses an equity curve. The overall result is a significant reduction in draw down with a fairly minimal impact on profits. 

This book covers all of the bases on relative strength investing and is simply a must read on this strategy. I haven't come across many books that were so easy to read yet  packed with so much information. 

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