Topic: How To Invest

Using a sector rotation strategy will eventually lead you to lower portfolio returns

Using a sector rotation strategy rarely works. That’s because you need to guess right twice to profit from sector rotation

We have long advised against practicing a top-down sector rotation strategy, and that advice hasn’t changed as we look ahead. Under-weighting or over-weighting sectors of the stock market depend on a forecast of the economic cycle or other factors. Few sector rotators succeed over long periods, because they need to guess right three times. They have to pick the top sectors, and they need to pick the stocks to rise within those economic sectors. and, finally, they must choose the stocks in that sector before they fall. Consistently succeeding at all three is extremely difficult.

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For example, if the finance sector was hot and receiving lots of investor attention, investors using a sector rotation strategy might rebalance their portfolios to overweight that sector and hold more financial stocks.

Some investors believe that sector rotation strategy can be a profitable approach to investing.

A sector rotation strategy may work in a given year when the economy behaves more or less predictably. However, it is difficult if not impossible to produce consistent longer-term returns with this strategy. Here are 3 reasons why:

  1. You need to guess right three times to profit from a sector rotation strategy: You have to pick the top sectors, then pick the stocks that will rise within those sectors, and then sell before the sector stumbles. It’s virtually impossible to consistently succeed at all three over long periods. But that’s not the only problem with this strategy.
  2. Sector rotation can push you into the worst-performing sectors: There are many theories about which sectors will outperform at any given stage of the economic cycle. But trying to pick winning sectors—and staying out of other sectors—seldom works over long periods. Investors who attempt to do so often wind up with heavy holdings in the worst-performing sectors. That would be devastating to your portfolio, even if you confine your investments to well-established companies.
  3. A sector rotation strategy costs money: Every time you move to a new sector you get charged fees twice. Once when you sell your holdings in the old sector and then again when you purchase holdings in the new sector. This may not be a big deal for investors who use discount brokers, but trading fees and commissions add up. These fees will eat into your profits.

Our approach gives you strong potential for long-term gains

Instead of using a sector rotation strategy, we advise you to diversify your holdings across the five main economic sectors: Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities. You will improve your chances of making money over long periods, no matter what happens in the market.

For example, manufacturing stocks may suffer if raw-material prices rise, but in that case your Resources stocks will gain. Rising wages can put pressure on manufacturers, but your Consumer stocks should do better as workers spend more.

If borrowers can’t pay back their loans, your Finance stocks will suffer. But high default rates usually lead to lower interest rates, which push up the value of your Utilities stocks.

Sector weightings

The proper proportions of how much you should hold in these sectors depends on your temperament and circumstances.

For example, conservative or income-seeking investors may want to emphasize utilities and Canadian banks in their portfolio diversification, because of these stocks’ high and generally secure dividends.

More aggressive investors might want to increase their portfolio weightings in Resources or Manufacturing stocks. For example, more aggressive investors could consider holding as much as, say, 25% to 30% of their portfolios in Resources.

However, you’ll want to spread your Resource holdings out among oil and gas, metals and other Resources stocks for diversification and exposure to a number of areas.

Overall sector volatility

Speaking very generally, stocks in the Resources & Commodities sector and the Manufacturing & industry sectors are apt to expose you to above-average volatility, while those in the Finance and Utilities sectors involve below-average volatility. Shares of many Finance-sector firms have been unusually volatile in the past few years because their industry is changing and expanding.

However, company profits in Finance and Utilities tend to be more stable over the long term than the profits of Resources or Manufacturing companies. Consumer-sector stocks are apt to fall in the middle, between the highly volatile Resources and Manufacturing companies and the more stable Finance and Utilities companies.

Have you used a sector rotation strategy in the past? Has it been profitable for you? Do you make a point of buying at least some stocks from the sectors you’re less comfortable with in order to have a diversified portfolio? e you enjoyed positive results when you diversify? Share your experience with us in the comments section below.

Note: This article was originally published in 2014 and is regularly updated.


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