What it means
Raw returns can be misleading. A stock that gains 10% in a year sounds good until you learn that the market gained 25%.
Relative strength puts performance in context by asking how an investment did compared with something else. Analysts compute it by dividing one asset's price (or return) by the benchmark's price (or return) and watching the ratio over time.
A rising ratio means the asset is outperforming; a falling ratio means it is lagging. Plotting that ratio on a chart makes leadership and weakness obvious at a glance.
Fund managers use relative strength to decide where to put new money, which sectors to overweight, and which holdings to trim. Some investment strategies, called momentum strategies, systematically buy assets with high relative strength and sell those with low relative strength.
Finance teams in companies also use the idea informally when they compare their own share price against a peer group after results. It is important not to confuse relative strength with the Relative Strength Index (RSI), which is a separate indicator.
The RSI measures the speed and size of an asset's recent price changes on a scale from 0 to 100 and does not compare the asset with anything else. Relative strength, by contrast, always involves a comparison.
The main limitation is that relative strength looks backwards. An asset that has led for a year can stall or reverse, and a very strong ratio can simply reflect that the benchmark did badly.
It works best as one input alongside valuation and earnings analysis. Relative strength also works at the level of whole asset classes and regions.
An allocator might compare emerging market shares with developed market shares, or small companies with large ones, to see where leadership is shifting. Those broad ratios often change slowly, which makes them useful for setting the direction of a portfolio rather than timing individual trades.
In practice
Real-world examples.
Example
A portfolio manager at a pension fund ranks the 11 sectors in her equity portfolio by their six-month relative strength against the overall market. Technology and healthcare are leading while utilities lag. She tilts new contributions towards the leaders and trims the laggards at the next rebalancing.
Example
The investor relations head at a retailer compares his company's share price with a basket of five competitors after a profit warning. The relative strength line shows the shares fell far more than peers, which tells him the market is reacting to company-specific problems rather than a sector downturn. He adjusts the message to investors accordingly.
Example
A private investor holds a gold mining stock that is up 8% over the year. A relative strength chart against a gold price index shows it has lagged the metal by 12 percentage points. She wonders whether poor management or high costs are the reason and reads the latest operating update.
Formula
Calculation
Relative strength ratio = (1 + asset return) / (1 + benchmark return)
Suppose a stock rose from $50 to $60 over a year, a gain of 10 / 50 = 20%. Over the same period the market index rose 5%. Relative strength ratio = 1.20 / 1.05 = 1.1429. A ratio above 1.00 means the stock outperformed; here it beat the index by about 14.3% in relative terms, even though the simple gap in returns is 20% - 5% = 15 percentage points.Case study
Seen in the real world.
Meridian Capital Partners is an illustrative, fictional investment firm that runs a mid-sized equity fund. Its analysts noticed that a manufacturing holding had risen 12% over the year, which the team considered satisfactory.
When they plotted the holding against its industry index, which had risen 30%, the relative strength line had been falling for nine months. The shares were going up, but they were losing ground to every competitor.
The team dug into the numbers and found that the company's margins were narrowing as rivals invested in newer equipment. Meridian reduced the position by half and reallocated the proceeds to stronger sector peers, and the illustrative lesson was that a positive return can still hide weak relative performance.
Watch out
Common mistakes.
- Confusing relative strength with the Relative Strength Index, which is a different indicator that does not compare an asset with any benchmark.
- Assuming a stock with high relative strength is cheap or safe, when it can simply be expensive and rising quickly.
- Choosing an unsuitable benchmark, such as comparing a small technology firm with a broad bond index, which makes the comparison meaningless.
Questions
People also ask.
How long a period should I use?
Analysts commonly look at three, six and twelve months, because a single short window can be distorted by one-off events, and consistent leadership across windows is more reliable.
Is relative strength the same as outperformance?
They are closely related, but relative strength is usually shown as a ratio line over time, while outperformance is often a single number for a period.
Can relative strength be negative?
The ratio itself stays positive, but a value below 1.00, or a downward sloping line, means the asset is underperforming the benchmark.
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