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Many investors spend their time trying to find a dark horse stock that will come out of nowhere to provide monster gains. While this can yield spectacular results for a lucky few, the majority of investors fail most of the time.
I take the exact opposite approach to investing. I look for stocks that have already proven themselves to be winners, waiting till they have a big lead before placing my bet.
To most investors, especially those considered value investors, this probably sounds ludicrous. We have all been taught we need to "buy low, sell high." So how can buying "high" possibly make for a sound investing strategy?
Well, I've never been a big gambler, but I do know a thing or two about odds. And I'd like to explain my strategy using a horse racing analogy.
Imagine you're at a horse race, and while everyone else is placing their bets before the race, you get to bet after the race has already begun.
In fact, you get to place your bet when there's already a clear leader who looks likely to win the race. After all, experienced bettors know horses that get an early lead are horses worth betting on.
So, while the other bettors place their wagers here...
You get to place your bet here…
At the very least, your horse is almost certain to show or place, which should lead to a tidy payday.
Relative strength (RS) investing is like betting on a horse after the race has already begun and you can see a clear leader.
RS is a pure measure of the price trend. It's not interested in undiscovered or low P/E stocks. It doesn't care if the company behind the stock has made a big gold or biotech discovery. And it's not interested in whether anyone is endorsing the stock on TV or in your email spam box.
All it cares about is finding stocks that are already on the move. If a stock is languishing -- no matter how "cheap" it is or how interesting its story may be -- RS is not going to signal a buy.
Now, does that mean it will potentially miss that rare dark horse stock that quadruples in price before most people have heard of it? Absolutely.
But I'm more than OK with that, because RS provides consistent market-beating results without having to risk your hard-earned money on fly-by-night companies that may or may not be the next great investment.
While RS has been proven again and again to be one of the most effective ways to find profitable stocks, most investors continue to ignore it, secure in the myth that they're better off buying stocks at "low" prices, i.e., those that have underperformed.
But study after study has shown that outperforming stocks are a far more profitable place for your money -- just like the horse that's leading on the final turn of the race.
For example, economist Eugene Fama won a Nobel Prize for his research that proves beyond a shadow of a doubt that outperforming stocks are more likely to keep moving higher than those that are underperforming. And at least two studies in the Journal of Finance -- published more than 20 years apart -- reached similar conclusions.
Even more surprising, a recent study reveals that the closer a stock's current price is to its 52-week high, the stronger its performance will be in the following months -- the exact opposite of what most investors have been led to believe.
Popular investment advice continues to insist that individual investors are best served avoiding outperforming stocks. It's no wonder so few investors make money in the stock market. They're selling the very stocks they should be buying!
To measure RS, I use a sophisticated piece of software that looks at how well every stock in my database has performed over the past six months in comparison with all the others. When the calculations are completed, the worst-performing stock will have a RS score of 0, while the best performer will score 100.
My computer then pulls out every stock with a RS score above 70, meaning those stocks have outperformed 70% of all the other stocks in the market during the past six months.
Now, with everything I've said about the profit power of relative strength, you might think I'd be tempted to stop right there and just start buying the stocks it identifies as the best.
But stocks often soar for no good reason -- a positive article in the financial media, rumors about a product that's about to take the world by storm, etc. -- and the ones that do can come crashing down just as quickly.
That's why I apply an all-important fundamental screen to stocks with a RS score over 70. To extend the horse racing metaphor a little further, it prevents me from betting on the horses that will break a leg on the last turn or will pull up lame in the home stretch.
I plan to cover this fundamental indicator in another article. But if you'd like to learn about it immediately or find out more about how you can put RS to work in your portfolio, I've put together a free presentation you can access here.
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