1. BECOME A SUCCESFULL
INVESTORA GUIDE TO ELEVATE YOUR INVESTMENT
PERFORMANCE WITH RELATIVE STRENGTH
• Low trading activity
• Low risk
• Substantial over performance
This book will change your view on investing and managing your nest egg for the future. With this book you can take control
of your investments and beat over 90% of all mutual fund managers. You only need a few minutes a week to manage this new
investment strategy that will make your life stress-free and profitable.
2. Table of Contents
Why you should read this book ...................................................3
About the authors at Nordbound................................................6
Introduction ..................................................................................7
Relative strength as an investment strategy ............................. 12
The history of relative strength .............................................. 15
Components in building a relative strength investment
strategy.................................................................................... 17
The investment universe ........................................................ 19
Relative strength lookback period .........................................23
Holdings...................................................................................26
Trading frequency...................................................................29
Your new investment strategy ................................................... 31
Global investment universe.................................................... 31
Standard lookback period ......................................................32
Two holdings give comfort .....................................................32
Trading twice per month ........................................................32
New Strategy – Level 1............................................................33
Going forward to execute this strategy – Level 1..................34
Your new risk managed investment strategy............................37
3. Risk management with absolute strength.............................37
New Strategy – Level 2............................................................38
Going forward to execute this strategy – Level 2.................. 41
Summary.....................................................................................44
Glossary.......................................................................................46
Notes ...........................................................................................55
4. Why you should read this book
The objective of this book is to give every investor the
information, tools, and solutions to take investment
performance to new levels by using a simple, robust, low
trading activity investment strategy. We are not only talking
about performance, but also about lowering your trading costs
or your costs for asset management. As professionals working
in the wealth management industry for over a decade, we have
a quite good understanding of what kind of performance
people have in their portfolios. There are, of course, individuals
who have seen much better performances, as well as those
who have seen much weaker results. We make the assumption
that the European investor generally has a performance
weaker than an actively managed mutual fund investing in
Europe. For example, an average European equity fund, BNP
Paribas L1 Equity Europe Classic-Cap, has a performance for
the last 10 years of 4.5 % per year. This means that the mutual
fund is underperforming the comparison index of MSCI Europe
by about 1 % each year.
Our objective in this book is to first get you from the mutual
fund performance of 4.5 % per year (2004 - 2014), to Level 1,
with an average performance of 8.8 % per year (2004 - 2014),
and finally to Level 2, with an average performance of 11.1 %
per year (2004 - 2014). Please see Chart 1 below.
5. Chart 1. This chart shows how different investments have performed during a time
period from early 2004 to early 2014. The horizontal axis shows the time period from
2004 to 2014. The vertical axis shows how these different investments have
performed. The starting value is 100 for each investment. The light grey line shows how
an average European mutual fund has performed during this time period, giving a
cumulative performance of 85 %. The darker grey line shows how your investments
would have performed during this time period if you had followed the first strategy
explained in this book. The cumulative performance of this New Strategy Level 1 was
137 %. The dark red line shows how your investments would have performed during
this time period if you had followed the second strategy explained in this book. The
cumulative performance of this New Strategy Level 2 was 206 %. Source: Bloomberg
2014, Ticker MSDEE15N
This strategy not only gives you a better performance, but also
lowers your risk and gives you a great advantage in your risk-
adjusted performance. You can achieve this kind of
performance by following a few easy steps and by investing
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New Strategy Level 1
New Strategy Level 2
6. only a small amount of time. Read on and you will find this to
be a much less stressful approach to investing.
With this investment strategy, you will be able to either invest
through ETFs (Exchange Traded Funds) or individual stocks and
avoid expensive wealth managers and underperforming
mutual funds. You can read more about our strategy in
chapters 10 and 11.
7. About the authors at Nordbound
We at Nordbound have been working in the wealth
management field for over a decade. We all have a master’s
degree in economics and have been working as portfolio
managers and wealth managers for several years. After
witnessing several market meltdowns and big losses in
customer portfolios, we started to develop a simple and robust
system to beat the stock market and move to the side as the
market melts down. Our core competence lies in relative
strength investment strategies, technical analysis and
investment strategy back-testing. We all hold portfolio
management positions at Nordbound. For more information
and updates, please visit: www.nordbound.com
8. Introduction
Since we have been working in the wealth management for
over a decade, we have seen the Asian financial crisis of 1997,
the dotcom bubble of 2000, the financial crisis of 2007 - 2008,
and the European debt crisis of 2011. We also witnessed the
stock market giving incredible returns during the time periods
of 1990 - 2000, 2003 - 2007, and 2009 - 2014. See Chart 2
below.
Chart 2. This chart shows how the global stock market has performed during a time
period from 1990 to early 2014, including dividends paid by underlying companies. The
horizontal axis shows the timeframe, and the vertical axis shows the performance of
the global stock market index starting from level 100. The 100 starting level means that
when it rises, for example, to 125, the market has risen 25 %. When it sinks to 75, the
market has retreated 25 %. Source: Bloomberg 2014, Ticker NDDUWI
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9. Two major problems that investors have been facing in the
stock market are sharp sell-offs and bear markets, which have
wiped away large portions of the returns made during earlier
bull markets. For example, the gains from the stock market
during 1996 - 2000 were wiped out between 2000 and 2002. It
took five years to reach pre-bear market levels, and then
investors faced another round of beating when returns were
yet again wiped away in the financial crisis of 2008.
A third problem is that people tend to make active allocation
decisions when the market is in a turning point, either entering
a bull- or bear market stage. This means that a lot of investors
are missing out on strong rebounds, which are often seen right
at the turning point when entering into a bull market stage. For
example, the rebound of the stock market in early 2009 lasted
for five months, and gains reached as much as 50 %. The
misjudgment in timing means that most investors have not
achieved the global stock markets yearly average return of 7 %
during the period 1997 - 2004. Incorrect allocation has much
to do with investors trying to act rational (in truth, many
investors act on emotion, and we often see reactionary,
panicked sell-offs). These are factors that have often yielded
unprofitable investments due to miscalculations in the
analyses.
A majority of banks, financial advisors, and mutual funds tend
to rely on rational thinking when giving advice to their
10. customers. They have equity analysts, macroeconomic
analysts, and others who attempt to predict the future based
on facts. They collect data from commonly-used databases,
such as Bloomberg and FactSet, which are considered to be
the most reliable sources of information, and make predictions
based on facts and future estimates. There is only one
problem: They do not tell us anything about the future
performance and direction of the stock market.
Making a living as a private banker or wealth manager is not
always easy. Most of the time, you are losing against the
market, and at times, bear markets can hit your customers’
portfolios hard. The decrease in portfolio value can be a true
tragedy. At the very least it causes severe stress. Most of the
customers have worked hard to build their wealth. Even
though we have seen bull- and bear markets come and go, the
problem never disappears: The bear markets always come at
the wrong time. People may be near retirement, and a drop of
30 - 40 % in portfolio value can be disastrous. It can take 10 -
20 years before portfolios recoup to the same levels as the
initial investment.
With this in mind, we started our research into the investment
field. Our goal has been to develop an investment strategy that
will keep you invested as the market enters a bull market, and
an exit strategy for when the market enters a bear market.
Sounds simple, doesn’t it? Well, read on and you will
11. experience a completely different approach to investing—
simple, effective, and boring, but with great performance.
We began searching for a solution in technical analysis. This
interesting field seemed to offer the most potent solution to
our problem. We spent many hours researching the subject
and made investments in the leading technical analysis
software packages. Technical analysis gave us insight into
market structures, trends, corrections, and different types of
market formation. The Art and Science of Technical Analysis is an
excellent book written by Adam Grimes, one of the best and
most respected technical investors of our times.
However, after hundreds of hours of work and many years of
testing, we did not get the result we wanted. But it did seem to
solve one problem. We could keep ourselves out of any bigger
market corrections. And we did not lose a cent during the
summer of 2011 drop in the stock market.
Solving the problem of staying out of big market corrections
brought up another problem: We were missing out on all the
sharp rallies after the market had bottomed out. Even after a
lot of fine-tuning of our parameters, we found that the market
is self-learning, and it was either triggering our stop-loss
orders, or trailing stop orders too soon. This does not mean
that you cannot make money or be a successful investor by
using technical analysis. We think it is possible, but a great deal
12. of software, systematic work, data mining, and back-testing is
required in order to be successful.
We have found a solution after years of research, thousands of
hours of work, and after losing a lot of money. This investment
strategy will change the way you think about investing. It
definitely changed our view of the entire concept.
The cornerstone of the strategy is relative strength combined
with absolute strength for risk management. The normal
investor tries to buy cheap and sell at a higher level. Our
strategy aims at buying at high price levels and selling at yet
higher levels. This may sound crazy, but read on and you will
understand how and why it works.
13. Relative strength as an investment strategy
The goal of investing is to sell something at a price that is
higher than what the investor paid for it. The problem an
investor faces is determining when prices are low enough to
indicate a buy signal, and when they are high enough to decide
that selling is the best choice. Relative strength addresses this
problem by quantifying how an investment vehicle is
performing as compared to other investment vehicles.
The idea is to buy the strongest performers (as measured
against the performance of the overall market), hold these
vehicles while capital gains accumulate, and sell them before
their performance deteriorates to the point where they are
among the weakest performers.
According to Investopedia’s (www.investopedia.com) definition
of relative strength:
Relative strength is a measure of the price trend of a
stock or other financial instrument compared to
another stock, instrument or industry. It is calculated
by taking the price of one asset and dividing it by
another. For example, if the price of Ford shares is $7
and the price of GM shares is $25, the relative strength
of Ford to GM is 0.28 ($7/25). This number is given
context when it is compared to the previous levels of
relative strength. If, for example, the relative strength
14. of Ford to GM ranges between 0.5 and 1 historically,
the current level of 0.28 suggests that Ford is
undervalued or GM is overvalued, or a mix of both.
The reason we know this is because the only way for
this ratio to increase back to its normal historical
range is for the numerator (number on the top of the
ratio, in this case the price of Ford) to increase, or the
denominator (number on the bottom of the ratio, in
our case the price of GM) to decrease. It should also
be noted that the ratio can also increase by
combining an upward price move of Ford with a
downward price move of GM. For example, if Ford
shares rose to $14 and GM shares fell to $20, the
relative strength would be 0.7, which is near the
middle of the historic trading range.
InvestorWords gives this definition:
A stock's price change over a period of time relative to
that of a market index, such as the S&P 500. The relative
strength of a stock is calculated by taking the
percentage price change of a stock over a set period of
time and ranking it on a scale of 1 to 100 against all
other stocks on the market, with 1 being worst and 100
being best. For example, a stock with a relative strength
of 90 has experienced a greater increase in its price over
the last year than the price increases experienced by 90
15. % of all other stocks on the market. Some technical
analysts, especially momentum investors, like stocks
with high relative strength rankings, believing that stocks
which have recently gone up are more likely to continue
going up. Other technical analysts believe that a very
high relative strength can be an indication that the stock
is overbought and is ready to fall. Relative strength is
really a "rear view mirror" metric, measuring only how
the stock has done in the past, not how it will do in the
future.
It is important to note that relative strength is often linked with
momentum investing. This is partially true, but relative strength
strategies differ from momentum strategies in that they always
have a clear exit strategy.
A simple approach is illustrated in Chart 3 and shows the five
largest stock markets in Europe.
As you can see, the Italian MIB has the highest performance of
these markets, meaning that it has the best relative
performance. The second best performer is the Swiss SMI
index. The German DAX and French CAC follow, trailed by the
index with the poorest relative strength, the UK’s FTSE. An
investor who follows a relative strength strategy would prefer
to invest in the top performing indices, such as Italy’s MIB and
Swiss SMI, while avoiding weaker performers.
16. Chart 3. This chart shows the performance of the five biggest stock markets in Europe.
The horizontal axis depicts the 12-month period from 09/2013 – 09/2014, and the
horizontal axis shows the indexed values beginning from 100. In relative strength, the
aim is to find the investment vehicle with the best relative performance, which in this
case is the Italian MIB stock index. The weakest performers are the UK FTSE with the
red line and the France CAC green line. We prefer the Italian MIB and avoid the UK
FTSE. Source: Bloomberg 2014
The history of relative strength
Relative strength has long been acknowledged as a valuable
and effective investment tool. Jesse Livermore, in Edwin
Lefebvre's 1923 classic book, Reminiscences of a Stock Operator,
noted that "stock prices are never too high to begin buying or
too low to begin selling." In other words, stocks showing high
relative strength are likely to continue to increase in price, and
it is better, from Livermore's perspective, to buy those stocks
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17. rather than to buy stocks with falling prices. Ever since
Lefebvre wrote those words, there have been many
discussions about the best way to precisely calculate when
prices are high on a relative basis and when they are low.
One of the first quantitative calculations of relative strength
appears in H. M. Gartley's "Relative Velocity Statistics: Their
Application in Portfolio Analysis," published in the April 1945
issue of the Financial Analysts Journal. To calculate velocity
statistics, Gartley wrote, "First it is necessary to select some
average or index to represent the broad market, such as the
Standard & Poor's 90-stock Index, the Dow-Jones 65-stock
Composite, or a more comprehensive measure… The next step is to
compute the comparable percentage advance or decline of the
individual stock in the swing… And finally, the percentage rise or
decline in the individual stock is divided by the corresponding move
in the base index and multiplied by 100, to give the ‘velocity rating’
of the stock."
Velocity ratings are very similar to what we now call beta, the
concept defined by 1990 Nobel Memorial Prize winner William
Sharpe. They also define the basic idea behind relative
strength, which is to mathematically compare an individual
stock's performance to that of the market. There are a number
of ways to calculate relative strength, but all end up measuring
a stocks’ momentum and comparing that value to the overall
market.
18. After Gartley, it would be more than 20 years until another
study on relative strength was published. In 1967, Robert Levy
published a detailed paper, conclusively demonstrating that
relative strength worked during his test period of 1960 - 1965.
He examined relative strength over various time frames and
then studied the future performance of stocks. The stocks that
had performed well over the previous 26 weeks tended to do
well in the subsequent 26-week period.
More recent publications by Michael J. Carr (2008), Mebane
Faber (2010), and Gary Antonacci (2014) have come to the
same conclusion, even though they had a different approach.
Relative strength investing works if you keep discipline and
control over your investment universe. There will be times
when it does not perform as you would hope, but there will be
times when your performance is stunning compared to the
investment universe or comparison index.
Components in building a relative strength
investment strategy
Returning to one of the definitions of relative strength
investing, “Relative strength is a measure of the price trend of a
stock or other financial instrument compared to another stock,
instrument, or industry. It is calculated by taking the price of
one asset and dividing it by another.” This sounds simple, and it
is true in theory, but in practice you are going to stumble.
19. When you start to compare one stock or equity index to
another stock or equity index, you have to consider the whole
picture. What are you trying to achieve? In our experience, a lot
of people say, “I want to get the best performance, and I am
willing to take some risks.” Both performance and risk are
subjective, and if you don’t quantify them, the situation
becomes problematic.
Investors can always state the yearly performance they want
because that can be quantified, and we can determine an
investment or portfolio solution to achieve it. Risk is also a very
subjective word. For one individual, a drawdown of 40 % is
acceptable, but for someone else, it is a disaster and causes
many sleepless nights.
Professional investors talk about volatility, which in
mathematical terms is measured as the standard deviation for
the historical price fluctuations for a given asset. In practice,
this means how much your portfolio performance has
historically varied (and is expected to vary) from the mean
performance. As an example, you have a portfolio of 100.000 €
and your portfolio has a 25 % standard deviation. This means
that the portfolio fluctuates in average value between 75,000 €
and 125,000 € in any given year.
So what can you be comfortable with? One important part of
developing a relative strength investment strategy is to select
20. the proper investment universe. An investment universe is
made up of all the investments you follow on a continuous
basis.
If you go back and look at Chart 3, and if those indices are the
ones you follow, then those five indices will be your investment
universe. When selecting the investment universe, you have to
consider the relative strength of the lookback period. This
means that you rank all the investments in the universe by
their performance over a specified period of time. Academic
research shows that depending on your investment universe,
an effective lookback period is between 6 and 24 months.
When you have specified the lookback period, you have to
make decisions concerning the amount of holdings at each
time.
The last component to consider is the trading frequency.
Trading frequency refers to how often you are going to check
the ranking of your investment universe and possibly make
changes.
The investment universe
The investment universe contains all the possible investments
that you are tracking and are ready to invest in as the
opportunity arises. It can be made up of stocks in an equity
index, such as the FTSE 100, which means that your investment
universe consists of the 100 largest and most-traded stocks on
21. the London stock exchange. An investment universe can
consist of European indices, such as the German DAX, the
French CAC, the UK’s FTSE 100 UK, the Italian MIB, and others.
When we began working as professional asset managers, we
tried to follow everything on the market: Nordic Stocks, US
stocks, sector indices, currencies, commodities, and more,
ending up with several hundred different investment vehicles.
Confusing? Yes! Did we have control? No! Did it help us to
make great investments? No!
A decade later, we started to research relative strength, and
many books talked about the endless possibilities of relative
strength and how to handle different investment vehicles, such
as commodities, currencies, stock indices, bonds, and equities.
It sounded too good to be true, and in most cases, it is.
We began our relative strength journey by selecting an
investment universe of about 100 different investment
vehicles. We had all individual countries in our investment
universe, both in developed and emerging markets. We
selected different commodities, such as agriculture, natural
gas, and oil. We had the currency pairs EUR/USD and EUR/JPY.
We had different types of bond indices: corporate bonds, high-
yield bonds, and emerging market bonds. We ended up with a
universe of over 100 vehicles because We did not want to miss
out on any strong market trends. We were feeling the rising
22. market, and our investments were making great gains, but as
the market made corrections, our models indicated a lot of
sell-and-buy signals on different investment vehicles, which
caused a lot of trading. We invested for years with hundreds of
trades and realized that all our gains were eaten up by trading
costs and losses on market spread.
We knew we had something here, but we did not know how to
solve it until we became fanatical backtesters. Backtesting
means that you test your investment strategy on a fictional
platform to see how it would have performed historically.
Although backtesting is a common practice in the big hedge
fund companies, it is quite complex and learning it involves a
lot of work. A major part of backtesting uses software packages
such as Bloomberg Professional and TradeStation. But guess
what? Relative strength backtesting is not available in
Bloomberg, meaning that we have some advantage over the
“big guys.”
With backtesting software specifically designed for relative-
strength backtesting, we have the means to test different
investment universes and see how they react to different
components and investment vehicles. A very clear signal for
most investors is to have quite a small investment universe of
investment vehicles with low correlation. Even though we say
that the investment vehicles should have low correlation with
23. one another, they also need to have some kind of natural
common movement. If you have too-high correlation between
the vehicles, it will give you sharp drawdowns from the top
when a trend is ending. If you mix commodities with equities,
or blend bonds with equities, you will end up with investments
that have totally different cycles, resulting in a lagging
performance.
Our advice is to select small investment universes of 10 - 20
stock indices if you prefer using ETFs or mutual funds, and 30 -
40 different stocks if you prefer to invest directly in individual
stocks.
The investment universe has two effects on your portfolio. It
gives you the return, and it gives you a number of trades. If you
are an active investor, you can use a larger investment universe
with more trades. If you are more passive, you will want to
select a universe with less investment vehicles. Chart 4
illustrates the different investment universes of 40 vehicles, 15
vehicles, and four vehicles, with their corresponding trades and
the yearly average trades.
24. Chart 4. This chart shows how a larger investment universe leads to higher trading
frequency. The left vertical axis shows the number of investments in the investment
universe and the yearly average trades in a portfolio. The right vertical axis shows the
total amounts of trades in a portfolio. The horizontal axis shows the different
portfolios: case 1 is a portfolio with 40 investment vehicles, case 2 is a portfolio with 15
investment vehicles, and case 3 is a portfolio with four investment vehicles. It is
important to remember that high trading frequency can cause a lot of costs for
commissions and spreads. Source: Bloomberg 2014
Relative strength lookback period
Relative strength means that you are comparing different
investment vehicles. To make this comparison, you have to
calculate each vehicle’s performance over a specific time
period and then compare them. When you have determined
the performance of all the investment vehicles in your specified
investment universe, you can rank them. You start with the
best-performing vehicle and assign it a one; the second- best
vehicle receives a two and so on. However, you must also take
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25. the time period into account before ranking the vehicles.
Academic research says that lookback periods of 6 - 24 months
provide a better performance than the underlying index. This is
probably the best kept secret of every relative strength
investor. This is quite understandable because you will only get
the right answer by performing time-consuming backtesting
calculations that generate a massive amount of data.
The stock market is very dynamic, which means that it has a
tendency to randomly change over time, meaning in turn that
the relative strength investor is always backtesting to work with
optimal parameters.
In our experience with thousands of backtests, we can say, with
a high probability of accuracy, that using a 12-month lookback
period is quite safe. If your chosen investment universe
consists of individual stocks with a high historical risk level, you
should choose a slightly longer lookback period. On the other
hand, if your investment universe consists of large equity
indices in stable markets, you can opt for a shorter lookback
time.
Remember that we are now talking about fine-tuning, and
within the general parameter, you will have great over-
performance. The mechanism of selecting the lookback period
has to do with the flexibility you need to show as an investor.
You have to provide leeway for an investment vehicle to
26. perform and to correct itself. By giving the proper amount of
flexibility, individual stocks will exhibit extreme performance,
and the same stocks will also have substantial pullbacks. You
do not want to be out of a stock when it makes a pullback, but
then turns up to gain a new high.
If you have a very short lookback period, you will have a lot of
trading in your portfolio. If your lookback period is too long,
you will experience lagging performance as the reaction time
gets longer. Chart 5 shows trading activity performance with
different lookback periods. As the figure shows, the total
amount of trades reduces significantly as the lookback period
is increased.
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27. Chart 5. This chart shows how changing the lookback period affects the trading activity.
The vertical axis to the left shows the number of investment vehicles in the investment
universe and the length of the lookback period in months. The vertical axis to the right
shows the amount of total trades. The horizontal axis shows the different portfolios. All
portfolios have 40 investment vehicles, with only the lookback period changing. Case 1
has a look back period of six months, case 2 has a lookback period of nine months,
case 3 has a lookback period of 12 months and case 4 has a lookback period of 15
months. It is important to remember that high trading frequency can cause a lot of
costs for commissions and spread. Source: Bloomberg 2014
Holdings
We have now looked at the investment universe and the
lookback time for relative strength, but we still have one crucial
component to consider. When you invest in equities or stocks,
you always have to think about risk. Risk can be divided in two
categories: market risk and individual risk with a stock or single
index. The market risk cannot be eliminated (it can be
eliminated with derivatives), but risk with a single investment
can be lowered with a diversified portfolio.
The classical portfolio theory states that when you buy 10
different stocks, you have almost diversified the single risk to
an acceptable level. Even though diversifying feels like the
logical thing to do, it is also the single biggest reason for poor
or below-index performance in portfolios or mutual funds.
Relative strength investing tries to avoid diversifying and looks
for exposure to a small number of investment vehicles. A
typical asset manager or mutual fund takes only limited
28. exposure to “interesting” markets to avoid failure if it turns out
to be a wrong decision. A European mutual fund will typically
invest 30 % in the UK, 15 % in Germany, 15 % in France, 15 %
in Switzerland, and 15 % in the rest of Europe, varying these
weights with +-5 %. One missed judgment and you will have
below average performance.
Relative strength strategies take an active stand to investing by
allocating almost everything to a strong area. In this European
example, it could mean that you would be investing 50 % in the
Italy MIB and 50 % in the German DAX.
It is also important to understand that if you are looking at an
equity index such as the German DAX index that has been
rising 15 % over the past 12 months, it does not mean that
every stock has been on the rise. Often the rally in an index is
caused by big gains in a limited number of stocks. Relative
strength catches those movers at an appropriate time.
Remember: To get a great performance you have to
concentrate your investments and not focus on diversifying.
The number of holdings, like stocks or equity-index ETFs, not
only has an impact on diversification, but it exerts a
tremendous impact on the portfolio’s trading activity. The more
investment vehicles you have in the portfolio, the more you will
trade and cause poorer performance through costs and
slippage on spreads.
29. This is an area where you have to compromise and decide
upon the most advantageous number of holdings to get the
results you want. As a rule of thumb, when you use a stock
universe of 40 individual stocks, the holdings can be in the
range of six to nine stocks. If you are using equity indices with
an investment universe of 10 indices, you could look at two to
four holdings. Chart 6 illustrates how different numbers of
holdings result in higher and lower trading activity.
Chart 6. This chart shows how different numbers of holdings in your portfolio are
reflected in higher or lower trading activity. The vertical axis to the left shows the
number of investment vehicles in the investment universe and the total number of
trades that occurred during the time period of 2004 - 2014. The vertical axis to the
right shows the number of holdings in the portfolio. The horizontal axis shows the
different portfolios: case 1 is a portfolio with 40 investment vehicles with 10 holdings in
the portfolio, case 2 is a portfolio with 40 investment vehicles with seven holdings in
0
1
2
3
4
5
0
10
20
30
40
50
60
1 2 3 4
TradingFrequency/Month
Investment Universe Trades 2004-2014 Trading Frequency / Month
30. the portfolio, case 3 is a portfolio with 40 investment vehicles with five holdings in the
portfolio, and case 4 is a portfolio with 40 investment vehicles with three holdings in
the portfolio. It is important to remember that high trading frequency can cause a lot
of costs for commissions and spread. Source: Bloomberg 2014
Trading frequency
Trading frequency is a very important aspect of investing and
must be considered with care in order to obtain the best
result. Trading frequency refers to how often you check the
rank of your investment vehicles and how ready you are to
make any changes needed.
The market has a dynamic life, and you have to let it correct
itself and allow space for investment vehicles to reach new
highs. If you check your investment universe every day and
make changes to the portfolio as needed, you may end up with
a great number of trades. If you are trading too slowly, you may
become stuck in investments that have already been sinking
and have entered a bear market. This is an area where you
have to compromise to find a balance between trading and
holding.
The more risk your investments show as measured by
standard deviation, the less you have to trade. When you have
an investment universe with a low standard deviation, more
frequent trading activity is necessary. To gain a better
understanding, we can say that for large equity indices, a
trading activity of twice per month is sufficient. For individual
31. stock portfolios, a trading activity of once per month is
adequate. Chart 7 shows how the total number of trades
decreases as the trading frequency decreases.
Chart 7. This chart shows how the trading frequency affects the total number of trades
during the period of 2004 - 2014. The vertical axis to the left shows the number of
investment vehicles in the investment universe and the total number of trades in the
portfolio during the time period of 2004 - 2014. The vertical axis to the right shows the
monthly trading frequency in the portfolio. The horizontal axis shows the different
portfolios: all portfolios have 40 investment vehicles, with only the trading frequency
changing. Case 1 has a weekly trading frequency, case 2 has a trading frequency of
three times per month, case 3 has a trading frequency of two times per month or bi-
weekly, and case 4 has a trading activity of one time per month. It is important to
remember that high trading frequency can cause a lot of costs for commissions and
spread. Source: Bloomberg 2014
0
2
4
6
8
10
12
0
20
40
60
80
100
120
140
1 2 3 4
Holdings
Investment Universe Trades 2004-2014 Holdings
32. Your new investment strategy
We have considered several of the key components of relative
strength, and now it is time to take you from the average
European investor to Level 1 investing, where you almost
double your performance with little effort. We are going to use
ETFs as vehicles because of their clear dominance over mutual
funds. ETFs are index funds that are traded daily on the stock
market like normal stocks. The available range of ETFs is very
large, and only your imagination limits your selection. But
always remember that you want to keep it simple!
Global investment universe
Our first job is to select an investment universe that will take
you to Level 1. Even though our home market is Europe,
looking outside the box is highly recommended. You can do
that with the relative strength of a clear rule-based investment
approach. The problem with Europe or another limited area is
that the internal stock markets have a high correlation, making
it difficult to find trends outside the general market.
We will now take a rather conservative approach by selecting
four different geographical areas: North America, Europe,
developed Pacific Asia, and emerging markets. This means that
our investment universe consists of four investment vehicles.
Even though it may seem very simplistic, these areas represent
different economies with different cycles. North America has a
33. very dynamic economy, Europe has a rather conservative and
stiff economy, Pacific Asia takes advantage of growing
emerging markets, and the emerging markets offer high
potential with high risk.
Standard lookback period
The lookback period can always be optimized by extensive
backtesting. However, it is quite smart to be conservative in
this area and select a 12-month lookback period. This will work
well and give needed stability to investors. We have to keep in
mind that a robust relative strength strategy is not very
sensitive to the changes of a lookback period if we are
analyzing a range of 6 - 15 months.
Two holdings give comfort
The amount of holdings, at any time, always raises the trading
activity and does not statistically give any lower risk because of
the natural mechanism in the strategy. We are settling on two
holdings to make you more comfortable as you begin this
investment strategy.
Trading twice per month
As we noted earlier, the trading frequency has an impact on
the total number of trades expected. In many cases, a trading
frequency of once per month is sufficient, but you will probably
feel much more comfortable with trading twice per month. It is
important to remember that trading activity means how often
34. you evaluate the relative strength rankings. Only make changes
if an investment has fallen below the 50% line.
New Strategy – Level 1
Here is your new relative strength investment strategy. The
historical performance from 2004 to the end of 2013 shows a
total return of 138 % when the European stock market
advanced 84.7 %. The compound annual growth rate (CAGR),
or effective yearly performance, was 8.2 % as the European
market in general performed at a CAGR of 4.5 %. With this
strategy, you can expect to make three to four trades each
year. Chart 8 and Chart 9 illustrate these concepts.
Chart 8. This chart shows how the New Investment Strategy 1 has performed
compared to the average European investor from early 2004 to early 2014. The vertical
50.00
75.00
100.00
125.00
150.00
175.00
200.00
225.00
250.00
275.00
300.00
325.00
1/1/2004 1/1/2006 1/1/2008 1/1/2010 1/1/2012 1/1/2014
Europe Equity Investor
New Strategy Level 1
35. axis shows the indexed values for each investment strategy with 100 as the starting
point. The light grey line shows how an average European mutual fund has performed
during this time period, giving a cumulative performance of 85 %. The dark gtey line
shows how your investments would have performed during this time period if you had
followed the strategy explained in this book. The cumulative performance of this New
Strategy Level 1 was 137 %. Source: Bloomberg 2014
Chart 9. This chart shows the metrics of the investment strategy called “New Strategy
Level 1.” The vertical axis to the left shows the value or % of each metric. This chart
shows that this portfolio had a total of 36 trades during the time period of 2004 - 2014.
The performance of this portfolio generated a cumulative return of 138 % and a
compounded annual growth rate of 8.2 % / year. The risk in this portfolio, measured by
standard deviation, was 23 % on an annual basis. Source: Bloomberg 2014
Going forward to execute this strategy – Level 1
This is a simple, robust, and market-beating strategy that is
easy to manage and perform on a regular basis. You only need
0
20
40
60
80
100
120
140
160
Total trades 2004-2014 Profit % CAGR % Annual Standard
Deviation
New Strategy Level 1
36. 15 to 20 minutes twice per month, a computer with internet
access, and a spreadsheet program similar to Excel.
This strategy has an investment universe consisting of North
American equities, European equities, Pacific Asian equities,
and emerging market equities. We are using ETFs as
investment vehicles. You can use the following ETFs managed
by iShares or other ETFs as long as they follow the same
underlying markets: iShares MSCI North America (IQQN),
iShares MSCI Europe (EUNK), iShares MSCI Pacific ex-Japan
(EUNJ), and iShares MSCI Emerging Markets (EUNM).
One reliable source to find the performance of investments is
the free Bloomberg web site www.bloomberg.com. Enter the
ticker, and you will find the ETF and its performance. For
example, IQQN will come up as IQQN. GR stands for the
German stock market, the best market to trade and follow in
Europe.
Now, we will build a spreadsheet with the different ETFs. There
are only four, so this is very simple as is seen in Table 10.
Table 10. This excel sheet is a tool to manage your investments. The ETF column
stands for the different investment vehicles that are used. These are the names of the
products used. The ticker column stands for the exchange codes used to identify
ETF Ticker 12 months Performance % Rank
iShares MSCI North America IQQN.GR 25,22 1 Buy
iShares MSCI Europe EUNK.GR 12,67 2 Buy
iShares MSCI Emerging Markets EUNM:GR 10,10 3 Sell
iShares MSCI Pacific ex-Japan EUNJ.GR 7,06 4 Sell
37. investment vehicles on detail. The column “12 month performance %” stands for the
performances of these investment vehicles during the 12-month period. Rank column
stands for the relative strength ranking in this investment universe of the four
investment vehicles. The last column indicates if the rank is high enough to get a buy
signal. Source: www.Bloomberg.com
Now, put 50 % of the money you wish to invest in iShares MSCI
North America and 50% in iShares MSCI Europe. Chart 10a
illustrates the actual portfolio content.
Table 10a. This excel chart demonstrates the portfolio content.
Twice a month, for example on the 15th
and on the last day of
the month, check the performance, fill in this sheet, and rank
the ETFs according to performance. If the European ETF falls to
Rank 3, sell it and buy the one that has risen to Position 2. Very
simple, yet extremely effective.
50%50%
0%0%0% iShares MSCI North
America
iShares MSCI Europe
iShares MSCI Emerging
Markets
iShares MSCI Pacific ex-
Japan
Cash
38. Your new risk managed investment strategy
We have now beaten the market and developed a simple, but
effective, strategy with a low trading activity. Our only concern
is this portfolio’s risk. If you look at the performance chart, you
will notice that the big drop in 2008 would not have protected
you in any way. To develop an investment strategy that inspires
you with the confidence you need to follow it, you need a risk
management system to protect your money against big market
corrections like the tech bubble of 2000 or the financial crisis
of 2008.
Risk management with absolute strength
Relative strength investing has been considered a high-risk
strategy because the drawdowns are quite high as the market
shifts trends. As we mentioned earlier, we have been analyzing
the technical aspects of risk management but have not yet
found a stable system. You can always come up with a
technical indicator that seems to work, such as moving
average, MACD, or the Heikin-Ashi technique, but the market is
dynamic and it can kick you out or get you back in at the wrong
point in time.
One of the best risk management systems is very simple. In
this case, we are using absolute strength. Absolute strength
was developed by Gary Antonaccio, who conducted extensive
research on the system for at least 50 years into the past.
39. With absolute strength, every investment must have a positive
performance during the last 12 months. With relative strength
investing, you only compare investments to one another and
not to any absolute levels. When all your investments have a
positive absolute strength, you know that you are not in a
general bear market. We are now going to take you to the
second level of this new investment strategy.
New Strategy – Level 2
This new strategy is exactly the same as Level 1, but we are
now adding the absolute strength risk management
component. This means that every investment that you make
must have had a positive performance during the last 12
months. If it is negative, you stay in cash even if it ranks at the
first or second position. This is very simple to track as you
follow the performance every second week.
When we added this risk management component, the
performance jumped from a total return of 138 % to 179 %.
The yearly CAGR rose from 8.2 % per year to 9.8 %. The most
important aspect was the dramatically lower standard
deviation, which sank to 15.9 % from the earlier 23 % level. We
were also able to lower the trading activity to 25 total trades
from the earlier 36. Chart 11 and Chart 12 illustrate the
strategy.
40. Chart 11. This chart shows how our presented strategies have performed during a
time period from early 2004 to early 2014. The horizontal axis shows the time period
from 2004 - 2014. The vertical axis shows the indexed value for each investment
strategy with the starting value 100. The dark grey line shows how your investments
would have performed during this time period if you had followed the first strategy
explained in this book. The cumulative performance of this New Strategy Level 1 was
137 %. The darker red line shows how your investments would have performed during
this time period if you had followed the second strategy explained in this book. The
cumulative performance of this New Strategy Level 2 was 206 %. Source: Bloomberg
2014
75.00
100.00
125.00
150.00
175.00
200.00
225.00
250.00
275.00
300.00
325.00
1/1/2004 1/1/2006 1/1/2008 1/1/2010 1/1/2012 1/1/2014
New Strategy Level 1
New Strategy Level 2
41. Chart 12. This chart shows the metrics of the investment strategy “New Strategy Level
1” compared to the investment strategy “New Strategy Level 2.” The vertical axis to the
left shows the value, or %, of each metric. This chart shows that “New Strategy Level 2”
had less trades, better total profit, and lower risk than “New Strategy Level 1” during
the time period of 2004 - 2014. Source: Bloomberg 2014
Level 2 strategy is a very simple, robust, and market-beating
investment strategy that gives a stunning performance and
protects your capital when the market turns down and enters
a bear market. You will conduct only two or three trades each
year, giving you minimal management fees in the underlying
ETFs (0.3 %) and trading costs that you pay to the broker or
bank.
0
20
40
60
80
100
120
140
160
180
200
Total trades 2004-2014 Profit % CAGR % Annual Standard
Deviation
New Strategy Level 2
New Strategy Level 1
42. Going forward to execute this strategy – Level 2
This is a simple, robust, and market-beating strategy that is
easy to manage and perform on a regular basis. You only need
15 to 20 minutes twice per month, a computer with internet
access, and a spread sheet program similar to Excel.
This strategy has an investment universe consisting of North
American equities, European equities, Pacific Asian equities,
and emerging market equities. We are using ETFs as
investment vehicles. You can use the following ETFs, managed
by iShares or other ETFs, as long as they follow the same
underlying markets: iShares MSCI North America (IQQN),
iShares MSCI Europe (EUNK), iShares MSCI Pacific ex-Japan
(EUNJ), and iShares MSCI Emerging Markets (EUNM).
One reliable source to find the performance of investments is
the free Bloomberg website www.bloomberg.com. Enter the
ticker, and you will find the ETF and its performance. For
example, IQQN will come up as IQQN.GR for the German stock
market, the best market to trade and follow in Europe.
Now we will build a spread sheet with the different ETFs. There
are only four, so this is very simple as is seen in Table 13. This
table has the risk management component to protect the
capital as the market enters a longer downturn.
43. Table 13. This excel sheet is a tool to manage your investments. The ETF column
stands for the different investment vehicles that are used. These are the names of the
products used. The ticker column stands for the exchange codes used to identify
investment vehicles on detail. The column “12 month performance %” stands for the
performance these investment vehicles have performed during the 12-month period.
Rank column stands for the relative strength ranking in this investment universe of the
four investment vehicles. The signal column indicates whether the rank is high enough
to get a buy signal. The final column is the risk management area. Source:
www.Bloomberg.com
Now we put 50 % of the money you wish to invest in iShares
MSCI North America and 50% in cash. As you see iShares MSCI
Europe has a negative 12-months performance, so instead of
investing in Europe, we go to cash. Chart 13a illustrates the
actual portfolio content.
ETF Ticker
12 months
Performance %
Rank Signal
Risk
Management
iShares MSCI North America IQQN.GR 15,22 1 Buy Buy
iShares MSCI Europe EUNK.GR -2,67 2 Cash Negative
iShares MSCI Emerging Markets EUNM:GR -5,10 3 Sell Negative
iShares MSCI Pacific ex-Japan EUNJ.GR -7,06 4 Sell Negative
44. Table 13a. This excel chart demonstrates the portfolio content.
Twice a month, for example on the 15th
and on the last day of
the month, check the performance, fill in this sheet, and rank
the ETFs according to performance. Now you wait for some of
the investments rise to positive territory, and you can add
them to the portfolio. Very simple, yet extremely effective.
50%
0%0%0%
50%
iShares MSCI North
America
iShares MSCI Europe
iShares MSCI Emerging
Markets
iShares MSCI Pacific ex-
Japan
Cash
45. Summary
Every investor wants to beat the market and ultimately get real
profits that can be used to do whatever everyone wants to do
in their lives. Some like to travel, others buy cars or a dream
house in the south. Some people want to leave wealth to their
children or grandchildren.
Investing is getting harder as data flows from China to Europe
and back in microseconds, and no one has an advantage like
some did decades ago.
Almost all investment strategies are based on fundamental
factors or some technical indicators or combinations of them.
The problem with these investment strategies is that they
constantly lag behind the performance of the underlying
market or comparison index. The market is very efficient and is
dominated by trading computers using advanced algorithms.
This book is about how you can beat the stock market and
avoid the big bear markets just by using simple rules and a
clear investment strategy. The investment strategy presented
in this book is based on relative strength and a special risk-
management component. Investing with relative strength
means that you are following a limited number of investments
and ranking them based on their performance relative to each
other. You are always investing in the top-performing
46. investment vehicles and staying invested as long as the
performance is relatively better than the others.
One of the challenges with relative strength investment
strategies has been the big drawdowns as the market enters a
sharp downturn. To manage this problem, we are using a
component called absolute strength. This component will
protect our capital from big losses but gives enough room for
investments to correct and trend higher.
This book offers a practical solution for every investor to use
on a regular basis. It will give you a clear advantage over
traditional asset managers and mutual fund managers. You will
get market-beating performance with a low trading activity.
There will be times when this strategy does not give over-
performance, but you will also experience times with massive
over-performance.
For more information about the authors or the investment
strategy, please visit: www.nordbound.com
47. Glossary
Backtesting: The process of testing a trading strategy on prior
time periods. Instead of applying a strategy for the
approaching time period, which could take years, a trader can
do a simulation of his or her trading strategy on relevant past
data in order to gauge its effectiveness.
Bear market: A bear market is a general decline in the stock
market over a period of time [7]. It is a transition from high
investor optimism to widespread investor fear and pessimism.
According to the Vanguard Group, "While there’s no agreed-
upon definition of a bear market, one generally accepted
measure is a price decline of 20% or more over at least a two-
month period.”
Beta: A measure of the volatility, or systematic risk, of a security
or a portfolio in comparison to the market as a whole. Beta is
used in the capital asset pricing model (CAPM), a model that
calculates the expected return of an asset based on its beta
and expected market returns. Beta is calculated using
regression analysis, and you can think of beta as the tendency
of a security's returns to respond to swings in the market. A
beta of one indicates that the security's price will move with the
market. A beta of less than one means that the security will be
less volatile than the market. A beta of greater than one
indicates that the security's price will be more volatile than the
48. market. For example, if a stock's beta is 1.2, it's theoretically
20% more volatile than the market.
Bond: A debt investment in which an investor loans money to
an entity (corporate or governmental) that borrows the funds
for a defined period of time at a fixed interest rate. Bonds are
used by companies, municipalities, states, and US and foreign
governments to finance a variety of projects and activities.
Bonds are commonly referred to as fixed-income securities
and are one of the three main asset classes, along with stocks
and cash equivalents.
Bull market: A bull market is a period of generally rising prices.
The start of a bull market is marked by widespread pessimism.
This point is when the "crowd" is the most "bearish." This
feeling of despondency changes to hope, "optimism," and
eventually euphoria.
CAGR: The year-over-year growth rate of an investment over a
specified period of time. The compound annual growth rate is
calculated by taking the nth root of the total percentage
growth rate, where n is the number of years in the period
being considered.
Commodities: A physical substance, such as food, grains, and
metals, which is interchangeable with another product of the
same type, and which investors buy or sell, usually through
49. futures contracts. The price of the commodity is subject to
supply and demand.
Corporate bond: A debt security issued by a corporation and
sold to investors. The backing for the bond is usually the
payment ability of the company, which is typically money to be
earned from future operations. In some cases, the company's
physical assets may be used as collateral for bonds. Corporate
bonds are considered higher risk than government bonds. As a
result, interest rates are almost always higher, even for top-
flight credit quality companies.
Currency pairs: Two currencies with exchange rates that are
traded in the retail forex market. The rates of exchange
between foreign currency pairs are calculated as the factor by
which a base currency is multiplied to yield an equivalent value
or purchasing power of foreign currency. The currency
exchange rates of foreign currency pairs float, meaning that
they change continually based on a multitude of factors.
Currency: Any form of money that is in public circulation.
Currency includes both hard money (coins) and soft money
(paper money).
Developed markets: Countries that have sound, well-
established economies and are therefore thought to offer
safer, more stable investment opportunities than developing
markets.
50. Emerging markets bond: Emerging market debt (EMD) is a term
used to encompass bonds issued by less developed countries.
EMD tends to have a lower credit rating than other sovereign
debt because of the increased economic and political risks.
Emerging markets: Emerging market is a term that investors
use to describe a developing country in which investment
would be expected to achieve higher returns but be
accompanied by greater risk. Global index providers
sometimes include in this category relatively wealthy countries
whose economies are still considered underdeveloped from a
regulatory point of view.
Equity: A stock or any other security representing an
ownership interest. In terms of investment strategies, equity
(stocks) is one of the principal asset classes. The other two are
fixed-income (bonds) and cash/cash-equivalents.
Exchange-traded fund: Exchange-traded funds (ETFs) are
securities that closely resemble index funds but can be bought
and sold during the day just like common stocks. These
investment vehicles allow investors a convenient way to
purchase a broad basket of securities in a single transaction.
Essentially, ETFs offer the convenience of a stock along with the
diversification of a mutual fund.
Heikin-Ashi: A type of candlestick chart that shares many
characteristics with standard candlestick charts, but differs
51. because of the values used to create each bar. Instead of using
the open-high-low-close (OHLC) bars like standard candlestick
charts, the Heikin-Ashi technique uses a modified formula. The
Heikin-Ashi technique is used by technical traders to identify a
given trend more easily. Hollow candles with no lower shadows
are used to signal a strong uptrend, while filled candles with no
higher shadow are used to identify a strong downtrend.
High-yield bond: A high-paying bond with a lower credit rating
than investment-grade corporate bonds, treasury bonds, and
municipal bonds. Because of the higher risk of default, these
bonds pay a higher yield than investment grade bonds. Based
on the two main credit rating agencies, high-yield bonds carry a
rating below 'BBB' from S&P, and below 'Baa' from Moody's.
Bonds with ratings at or above these levels are considered
investment grade. Credit ratings can be as low as 'D' (currently
in default), and most bonds with 'C' ratings or lower carry a
high risk of default; to compensate for this risk, yields will
typically be very high. Also known as "junk bonds."
Index: A statistical measure of change in an economy or a
securities market. In the case of financial markets, an index is
an imaginary portfolio of securities representing a particular
market or a portion of it. Each index has its own calculation
methodology and is usually expressed in terms of a change
from a base value. Thus, the percentage change is more
important than the actual numeric value.
52. MACD: Moving Average Convergence Divergence. A trend-
following momentum indicator that shows the relationship
between two moving averages of prices. The MACD is
calculated by subtracting the 26-day exponential moving
average (EMA) from the 12-day EMA. A nine-day EMA of the
MACD, called the "signal line," is then plotted on top of the
MACD, functioning as a trigger for buy and sell signals.
Momentum investing: An investment strategy that aims to
capitalize on the continuance of existing trends in the market.
The momentum investor believes that large increases in the
price of a security will be followed by additional gains and vice
versa for declining values.
Moving average: A widely-used indicator in technical analysis
that helps smooth out price action by filtering out the “noise”
from random price fluctuations. A moving average (MA) is a
trend-following or lagging indicator because it is based on past
prices.
Spread: The difference between the bid and the ask price of a
security or asset.
Standard deviation: A measure of the dispersion of a set of
data from its mean. The more spread apart the data, the
higher the deviation. Standard deviation is calculated as the
square root of variance. In finance, standard deviation is
applied to the annual rate of return of an investment to
53. measure the investment's volatility. Standard deviation is also
known as historical volatility and is used by investors as a
gauge for the amount of expected volatility.
Stop-loss order: An order placed with a broker to sell a security
when it reaches a certain price. A stop-loss order is designed
to limit an investor’s loss on a position in a security. Although
most investors associate a stop-loss order only with a long
position, it can also be used for a short position, in which case
the security would be bought if it trades above a defined price.
A stop-loss order takes the emotion out of trading decisions
and can be especially handy when one is on vacation or cannot
watch his/her position. However, execution is not guaranteed,
particularly in situations where trading in the stock is halted or
gaps down (or up) in price. Also known as a “stop order” or
“stop-market order.”
Trailing-stop order: A stop order that can be set at a defined
percentage away from a security's current market price. A
trailing stop for a long position would be set below the
security’s current market price; for a short position, it would be
set above the current price. A trailing stop is designed to
protect gains by enabling a trade to remain open and continue
to profit as long as the price is moving in the right direction,
but closing the trade if the price changes direction by a
specified percentage. A trailing stop can also specify a dollar
54. amount instead of a percentage. This is also known as a
“chandelier stop”.
55. Notes
Smarter investing in any economy, Michael J. Carr, 2008
Relative Strength Strategies for Investing, Mebane Faber, 2010
Risk Premia Harvesting Through Dual Momentum, Gary
Antonacci, 2013
Buy – Don`t Hold: Investing with ETFs, Leslie Masonson, 2010
The Art & Science of Technical Analysis, Adam Grimes, 2012