Every Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a new or experienced investor, these weekly updates are designed to give you specific advice on successful investing. Each Investor Toolkit update gives you a fundamental tip and shows you how you can put it into practice right away.

Tip of the week: “2 risks of following a sector rotation investment strategy”

Some investors follow a “sector rotation” approach to investing. That’s when you try to hop from sector to sector, underweighting or overweighting your 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 2 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.

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Our investment advice: Instead of sector rotation, we recommend that you diversify your portfolio by spreading your money out across most, if not all, of the five main economic sectors (Manufacturing & Industry, Resources & Commodities, the Consumer sector, Finance and Utilities).

(This is a key part of our three-part investing program. The other two parts are to invest mainly in well-established, dividend-paying companies and to avoid or downplay stocks in the broker/public-relations limelight.)

If you diversify as we advise, you 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.

Next Wednesday, January 5, 2011, Investor Toolkit will look at what to hold in your registered retirement savings plan (RRSP).

If you’d like me to personally apply my time-tested approach to your investments, you should consider becoming a client of my Successful Investor Wealth Management service. Click here to learn more.