Choosing where to invest your money is the most important decision you’ll make when you begin investing. Myriad theories posit the optimum means of investing your money, including relative strength analysis (RSA). This method attempts to understand the value of stocks in a relative, rather than objective, field -- hence its name. RSA begins with an underlying philosophy and contains elements of theory and practice.
The Philosophy of Relative Strength Analysis
The basic philosophy behind relative strength analysis lies in the idea that making money requires spending money. Or, more specifically, purchasing inexpensive shares with hopes of exponentially increased returns constitute something of a fool’s errand. As per RSA, investing large amounts of capital in the most highly rated, and often most expensive, stocks guarantees the highest rates of return. RSA philosophy holds that the value of stock lies in its relative strength or weakness when compared to other securities and commodities.
Relative Strength Analysis Theory
Basically, RSA suggests that investors should always purchase stock with the highest price performance at a given time. This theory bears a striking resemblance to momentum buying, which sees investors purchasing stocks on the rise with the idea of selling before the stock declines below previous levels. However, momentum buying consists of little more than informed guess work, while RSA holds that investors create a minimum level of profitability. When a stock dips below this level, you sell your shares without reservation. Furthermore, momentum only applies when stocks rise and fall in three months or less, while RSA may allow you to hold shares for much longer if successful.
RSA in Practice
Relative strength analysis practice begins with analysis. Two types of analysis exist, ratio and screening. Ratio allows you to compare the strength of focus stocks through ratios representing profitability. Screening constitutes a complex process performed by computer programs that compares a number of facets of a stock over a specific period of time. The actual analysis of RSA usually takes place over a long period of time -- sometimes as long as a year. During this time, analysts follow a select group of stocks, such as single index, and compare their profit values to one another for long enough to determine which constitute the best investments.
The Relative Strength Index
The relative strength index (RSI) constitutes a list of securities exhibiting relative strength at the close of the day, or those with a higher ending price than starting price. Despite the name, securities on the RSI differ significantly from stocks found strong by RSA, because RSA measures relative strength over a longer period of time than a single day. RSI actually measures the momentum of a stock more than it measures relative strength in the same way that RSA does.
- “Buy--DON'T Hold”; Leslie N. Masonson; 2010
- “The Encyclopedia of Technical Market Indicators”; Robert W. Colby; 2003
- “Intermarket Analysis: Profiting from Global Market Relationships”; John J. Murphy; 2004
- “Financial Markets for the Rest of Us”; Robert Vahid Hashemian; 2001
- “Technical Analysis for Beginners”; George Yioryalis; 2004
- Comstock/Comstock/Getty Images