Signs of a recovering economy are all around, from modest job creation to a strengthening housing market and rising consumer confidence.
To average folks, these indicators are good news on a gut level and a pocketbook level. But to devotees of what's known as sector rotation, they may be signals to start buying and selling. Average investors, however, should think twice about trying their hand at this investing approach.
Sector rotation is a simple and compelling idea: Because certain business sectors tend to profit more in specific stages of an economic cycle, jumping in and out of those sectors at the right time can put an investor one-up on the market. Think of a surfer positioning himself to catch one righteous wave after another.
Brad Sorensen, the director of market and sector analysis at the Schwab Center for Financial Research, is among those who believe there's a new wave to catch. He recently wrote that the time is right to move away from defensive sectors_such as, utilities and consumer staples_and toward sectors like consumer discretionary and industrials. Such "cyclical" business areas often do better when the economy is strengthening.
In sector rotation, investors make specific bets on which segments of the economy will thrive_or at least will not implode. During a recession, investors make a beeline for utility stocks. Households and businesses need to keep the lights on even when times are tough, after all. In a bustling economy, luxury retailers often thrive as confident consumers open their wallets to buy jewelry or expensive handbags.
Depending on the state of the economy and business trends, sector rotators move their money between the defensive areas — consumer staples, utilities and health care — and into more cyclical sectors.
Sector rotation may seem simple in part because of the profusion of sector-focused mutual funds and Exchange-Traded Funds. Alas, investing, just like surfing, is harder than it looks.
Two elements make the practice perilous. The first is predicting if and when that part of the economy will make its move. Do-it-yourself investors tend to be a step or two behind sophisticated professionals, who have access to better information. By the time they move their money into a sector, the early birds may have bid up prices.
"Generally, the sector that retail investors want to pour into is the one that has had the best performance as of late," says Bill Hammer, Jr., a financial planner in Melville, N.Y. "This is a surefire recipe for investment failure over the long run."
The current environment provides a good example of how tricky it can be to get the timing right. Schwab's Sorensen noted that the cyclical stock groups unexpectedly lagged through much of the recently ended rally. In other words, if you had dutifully rotated into those groups at the start of the year, you would have been too early.
Another challenge is knowing the correct percentage of your assets to invest in a given sector. Too little and you won't adequately participate in the gain; too much and you're at risk from under-diversification.
The larger problem with sector rotation is that it tends serve one goal: Beating the market. That might be fine if you've got "play money" that you don't mind losing. For most of us, investing should be a means to achieve specific long-range goals such as funding retirement or putting kids through college.
"If you're too focused on sector rotation, you end up being a speculator and not an investor," says Joe Jennings, investment director for PNC Wealth Management in Baltimore.
Even professional investors have a mixed record with picking the right sectors at the right time, he adds. It's not surprising. One year's top performer can be the next year's laggard; that's what happened with the utility sector between 2011 and 2012. Conversely, financials went from worst to first between 2011 and 2012.
What's more, the more-frequent buying and selling required to move your money around leads to increased costs, in the form of brokerage fees as well as the capital gains taxes that accrue when you sell for a profit.
Interestingly, the Standard & Poor's 500 index, which is composed of 10 sectors, has a cumulative return of 153 percent since the March 2009 market low. That's better than raw materials, utilities, telecom, consumer staples, energy, and health care, and about the same as technology, according to JP Morgan Asset Management. Only three sectors have beaten the overall market over that period by a substantial margin_financials, industrials and consumer discretionary. And that's an argument for balance and diversification.
Chasing sectors may get your adrenaline pumping, but it's incompatible with a solid, long-term plan. "It's more difficult to be disciplined," says Jennings. "You may not hit the grand slam, but you will get more consistent results."
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