The importance of diversifying your holdings while sector investing, and why it’s a smart idea to avoid a sector rotation strategy

Your portfolio strategy should begin with one of the three key elements of our Successful Investor philosophy: Spread your money out across most if not all of the five main economic sectors (Finance, Utilities, Manufacturing, Resources, and the Consumer sector).

The proportions in five sector investing depend on your objectives and the risk you can accept. The Canadian Finance and Utilities sectors involve below-average risk. Manufacturing and Resources tend to be riskier, and the Consumer sector is in the middle.

Where we set our limits for sector investing

We rarely if ever start out with a holding above 5% of the portfolio in any one stock. If a single stock comes to make up 10% or more of the total value, we consider taking some profits. But sometimes it pays to hold on to a rising stock, even if it comes to dominate the portfolio. This can depend partly on the sector the company is in.

Remember, Manufacturing and Resources are the two riskiest sectors, Canadian Finance and Utilities are the safest, and Consumer is in the middle.

A number of our portfolio management clients hold 10% to 20% or more of their wealth in a single Canadian bank stock, mostly inherited from a parent or grandparent. Often this inheritance came with clear instructions such as, “Spend the dividends, but don’t sell any of the shares unless you’re desperate!”

That advice has paid off. Many have gains of 1,000% to 2,000% or more, not even counting dividends. The outcome would have been less rewarding if the advice came with a bequest of a more volatile Manufacturing or Resources stock—General Motors, say, or Imperial Oil.

Holding a big part of your wealth in one stock still exposes you to some risk. To offset that risk, you get to defer the capital-gain tax. With bank stocks, you also get a rising stream of dividends. More to the point, the top banks have a powerful place in Canada’s economy and politics.

If you’re going to overload your portfolio in any sector or industry, the top Canadian banks are a good choice. The Manufacturing and Resources sectors, and even the Consumer sector, are far less dependable.

Why it’s important to avoid a sector rotation strategy while sector investing

Some investors follow a “sector rotation” approach to investing. That’s when you try to hop from sector to sector, underweighting or overweighting their holdings in certain sectors of the stock market depending on a forecast of the stage of the economic cycle, or other factors.

Sector rotation can work in any one year, say. However, it’s difficult if not impossible to produce consistent longer-term returns. Here are two reasons why:

1. You need to guess right three times to profit in sector rotation: You have to pick the top sectors, then pick the stocks that will rise within those sectors, 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 sector rotation.
2. Sector rotation can overweight you in 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.

If you diversify as we advise, you improve your chances of making money over long periods, no matter what happens in the market.

You need to make a judgment on sector investing

Stock performance varies widely within each of the five sectors, of course. The best Manufacturing or Resources stocks are likely to outperform the worst Finance or Utility stocks. So, before you let a single stock make up more than 10% of your portfolio, much less 20%, you’d want to make sure the stock has an attractive outlook and fits into your sector investing strategy well.

Have you ever used a sector rotation strategy to your advantage, or do you avoid that type of investing at all costs?