How to Use Relative Strength in Alternative Investing

January 18, 2022

If you say an investment is as good as gold, it doesn’t mean much. Relative to gold, it may have a rather short performance history. But compared with silver, it might perform a lot like gold.

This is more than just a semantic argument. An investment might look great on paper, but figuring out how it performs relative to other investments is an incredibly useful performance indicator. It’s called relative strength. And in alternative investing, it’s even more useful to figure out if an investment is the right fit for your portfolio.

Here’s a closer look at relative strength—and how to use relative strength in alternative investing strategies.

What is Relative Strength in Investing?

Relative strength is a strategy most commonly used in identifying value stocks and in momentum investing (a strategy aimed at capitalizing on the continuance of an existing market trend). It focuses on investments that have performed well compared to the market as a whole or a relevant benchmark.

In relative strength investment strategies, the goal is not to buy low and sell high—the goal is to buy high and sell even higher. Relative strength investing relies on the basic assumption that current market trends will continue long enough into the future for investors to capitalize on them. This means that the strategy works best in stable markets with minimal disruption. Otherwise, any sudden disruption will lead to negative results.

Like the Great Recession, for example. In a period of extreme turbulence, investor psychology flips on its head and yesterday’s great investments are cast away.

Because it’s most often used in momentum investing, the strategy is most commonly associated with individual stocks. However, you can use index funds or exchange-traded funds to apply the strategy to a complete market or sector. But as a strategy, you can apply it to other investments if you know how to use it correctly.

What is the Relative Strength Index?

Most analysts rely on the relative strength index (RSI), a momentum indicator measuring the magnitude of price changes to evaluate overbought or oversold conditions in an asset price. It’s typically used in technical analysis and was first introduced in 1978 by J. Welles Wilder Jr. in his book New Concepts in Technical Trading Systems.

RSI is calculated using a two-part formula, and the resulting RSI line can be plotted under an asset’s price chart. As the number and size of positive closes increases, RSI will increase.

If the RSI is above 70%, the asset is considered overbought. If the RSI is below 30%, the asset is considered oversold. The second half of the calculation smooths out the result so that you only see RSI near 0 or 100 in a strongly trending market.

RSI can stay in the overbought region for a while if the market is on an uptrend, or it can stay in the oversold region for a while if the market is on a downtrend. This can make RSI confusing, especially for new analysts, so it’s important to view RSI in context of the larger situation.

Relative Strength Index vs. Stochastic Oscillator

RSI is sometimes confused with stochastic oscillator, another type of momentum oscillator. They have similar objectives (projecting market trends), but the underlying theories are quite different.

A stochastic oscillator is a momentum indicator that compares a security’s closing price to its price range over a period of time. Like RSI, it’s range-bound, meaning the result is always between 0 and 100, which makes it useful for identifying overbought and oversold conditions. Similar to RSI, readings over 80 are considered overbought and readings under 20 are considered oversold. It can be especially confusing because the basic overall theory resembles RSI—if the market is trending up, prices close high, but if the market is trending down, prices close low.

However, despite apparent similarities, the two indicators use different measurements and assumptions. RSI tracks the velocity of price movements to track overbought and oversold market levels. A stochastic oscillator is calculated on the assumption that closing prices should confirm the current trend.

Why You Need to Compare Performance

Why all the fuss about comparing investments? Because when you get down to it, performance context matters.

Let’s say you have a lower-priced security. It’s easy to view such a security as a good value. Here’s the problem: if you’re buying low based on hope, you often end up selling lower. You’re only looking at the investment as a batch of numbers, not considering how other factors will influence the investment over time.

Relative strength provides context by examining market trends and how the asset performs in relation to them. That way, you can invest by capitalizing on those trends.

Why It’s Even More Important for Alternative Investments

This strategy is even more important for alternative investments, if only for one reason: their performance is often harder to track. In some cases, finding the history of the investment may be a challenge in itself.

Relative strength allows you to introduce context that you would otherwise lack. If you’re looking at a piece of art, for example, you can assess how the work or the artist performs relative to the rest of the market and in context of current art market trends.

How to View Relative Strength in Alternative Investing

Relative strength is best used for predicting bearish or bullish market conditions—in other words, what parts of the economy are performing well or performing poorly. This can allow you to hone in on high-performing sectors, which is especially useful in alternative investing since the assets often have a low stock market correlation.

Relative strength can also be used as a tactical tool to choose between assets for a tactical overweight and underweight. Comparing apples and oranges, so to speak.

Smart Investment Options to Grow Your Money

Relative strength in alternative investing provides crucial context that you need to make informed investment decisions. That way, you can see how an asset performs relative to conventional assets by using the same performance terms.

For example, blue-chip art prices have outpaced the S&P 500 by 180% from 2000–2018. That’s not relative strength analysis, by the way—that’s a real statistic on blue-chip art. And on our platform, regular investors like you can participate in blue-chip art investing by purchasing shares in authenticated multi-million-dollar art from high-growth artist markets with the highest potential risk-adjusted returns.

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Masterworks is a fintech company democratizing the art market. Our investors are able to fractionally invest in $1mn+ works of art by some of the world's most famous and sought-after artists.