The Danger of Chasing Hot Sectors
The way stock market returns are typically reported—"The market was up 5.7% last year"—masks the fact that at any point in time it's normal for some stocks to be faring well while others are languishing.
Indexes such as the S&P 500 and Wilshire 5000 include the stocks of companies from every industry and segment of our economy and represent the general performance of "the market" as a whole. But hidden beneath the surface of the market's overall performance are strong cross currents, driven by the action of the various industries that collectively make up the economy.
If it were obvious in advance which specific industries, or "sectors," would enjoy the biggest gains over the next few years, there wouldn't be any need to diversify.
Real life, of course, isn't so simple. Because it is so difficult to predict which sectors will excel, most investors chart a conservative course of investing in mutual funds that spread their investments among most or all of the various sectors.
Naturally some of these diversified fund managers tilt their portfolios more heavily towards some sectors than others, often a key factor that determines which funds fare particularly well or poorly over a specific time period. (The fact that different managers in the same risk category allocate differently among sectors is one important reason why Upgrading works on an ongoing basis.) But the idea of diversified mutual funds is to spread risk by investing across the industry spectrum.
Some investors, however, want to target a portion of their investing toward specific industries. To do this, they rely on "sector" funds. These are special purpose stock funds that limit their investing to a specific segment of the marketplace.
Rather than gaining broad diversification, investors in sector funds buy into a non-diversified portfolio that restricts its reach to a particular industry or investing theme.
When their particular industry is in favor, these funds really shine. But they have greater risk than diversified funds because when tough times hit the companies in the industry in which the fund specializes, the fund manager can't switch into something else. Because of their lack of flexibility, most sector funds carry higher risk than diversified funds.
The table above shows the average performance over the past two decades of sector funds that track several of the most prominent industry sectors. Each column displays performance for a three-year period, and the columns are color-coded to show at a glance how the performance of various sectors ebbs and flows in relative standing to each other.
The final two columns on the right display the average performance of each sector for the entire period, as well as the risk taken to achieve that performance. In all of the columns, including the final two, the best performers appear at the top of the column and the worst at the bottom (lower relative risk scores are better 
).
The chart vividly illustrates the continually changing undercurrents flowing through the stock market. It's common for one sector to be near the top of the group over one three-year period, then be near the bottom during the next period.
In fact, that's more the rule than the exception: in all but one period, at least one of the top three sectors followed its strong performance by landing among the bottom three sectors in the following period. It's unusual for a single sector to stay "hot" for a lengthy period of time.
Unfortunately, many investors sabotage their long-term returns by buying hot sectors at high prices and selling them at low prices. For example, think about the technology bubble at the end of the last decade. Sure, some investors got in early and rode the technology investing wave all the way up. But many, many more didn't buy tech stocks until late in the game, paying huge prices for stocks that were about to fall sharply.
That's fairly typical. Investors repeatedly chase the last trend, buying what's been hot over the past few years. But as the table shows, when a particular sector has been hot for a few years already, it's often about to slide to the back of the pack for awhile.
A BETTER WAY TO INVEST IN SECTORS
Thankfully, should you desire to invest in sector funds, there's a way to do so successfully. I'm referring to SMI's Sector Rotation strategy, which we highlighted a year ago in Sector Rotation: Risky, But Highly Rewarding . If you're not familiar with the Sector Rotation strategy already, read that article for a full explanation of how the strategy works.
Here's a quick summary: Sector Rotation ranks over 100 sector funds each month using a modified version of our Upgrading momentum score. We then buy the top rated fund, holding it until it no longer ranks in the top one-fourth of our sector fund universe. As soon as it drops out of the top quartile, we sell it and replace it with the fund that is atop the SMI sector rankings at that time.
This Sector Rotation approach has been extremely successful, both in our backtesting from 1990 forward, as well as in our real-time application of the strategy since November 2003. It's very simple, requiring attention just once per month, yet it has produced exceptional returns. However, the strategy is sufficiently volatile that we designate it an Advanced Strategy and recommend limiting it to no more than 5-15% of your total portfolio.
You can learn all the details regarding SMI's Sector Rotation strategy by visiting the Advanced Strategies page.
CONCLUSION
The main point to take away from this article is the value of diversification. Generally, hitching your cart to one particular sector is a bad idea that normally results in frustration and subpar returns. In contrast, buying diversified mutual funds that invest across all sectors offers a convenient and effective way to greatly reduce volatility while providing returns that are roughly in line with what the individual sector funds tend to earn over time anyway.
For the adventurous, sector investing does provide an opportunity to earn outstanding returns. But even within a system like SMI's Sector Rotation strategy, you have to understand that some very significant losses will likely occur along the way, and you need to have the conviction to stick with the strategy at those times of maximum pain.
If you can do that, allocating a small portion of your overall portfolio to sector investing through SMI's Sector Rotation strategy can provide a powerful boost to your long-term investing results. 
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Mark Biller is Sound Mind Investing's Executive Editor. His writings on a broad range of financial topics have been featured in a variety of national print and electronic media, and he has appeared as a financial commentator for various national and local radio programs. Mark is also the Senior Portfolio Manager of the SMI Funds. |
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