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The Importance of a Sector Rotation Plan

There is always plenty of banter regarding “market timing,” how important it is, how hard it is, whether it is an effective use of time and effort, etc. Depending on the prevailing market winds, temperament oscillates from rampant envy of those that appear to have mastered the art of market timing, to outright eschewing of the whole market timing hullabaloo. As we’ve said many times over, the real story is not whether one can consistently be effective at “market timing” (let’s just chalk that up as a timeless debate), but instead the far greater tactical opportunity for advisors that can be found in sector rotation. We could spend all of our effort dispelling the practice of “Buy & Hold” practices, strategic pie allocations, pure market timing, and the likes…or we could further the case for sector rotation, which is what we’ll do today. Whether you have already built a successful business upon the foundation of sector rotation, or you are looking to help make a stronger case for incorporating it into your business; we think you will find the updated graphics below useful for your endeavors.

This study presented below is one that we have published for years and it simply tracks the outcome of four hypothetical investors over the last 24 years. The first investor who we’ll term, “the Buy and Holder” simply buys the S&P 500 Index and rides it up and down, making no movements at all in the portfolio. Our second investor, is assumed to be clairvoyant and is only invested during months in which the S&P 500 Index is up. So, in 2008 this investor would have only been invested in April, May, August and December, as those were the only positive months in 2008. In our view, this is about as “perfect” as any “market timer” would strive to be, and thus we feel this pretty well quantifies the best case scenario for market timing.

Our last two investors were both sector investors, one of which had the ability to know each and every year what the best performing sector was going to be for that year, and they invested 100% of their portfolio in that sector. The fourth investor was an unfortunate fellow, who was perhaps just following a favorite magazine cover or something else that kept him on the wrong side of things each and every year as he managed to find the worst performing sector every year.

As you might imagine, each of the investors had dramatically different results from their initial investment of $10,000 back in 1993. Mr. Buy and Hold currently shows a portfolio value of $82,890. Mr. Perfect Market Timer has a portfolio value of $3.37 million. Ms. Perfect Sector Timer has seen her portfolio swell to $7.1 million! All while Mr. Poor Sector Timer’s portfolio has now fallen to a lowly $820.91! Said another way, the average annualized return for the Buy & Hold strategy since 1993 has been 9.21%, it increases to 27.42% for Perfect Market Timing, and is an astounding 31.44% for the Best Performing Sector. On the flip side, the average annualized return for the Worst Performing Sector portfolio is -9.89%. So that is the answer. It is that easy, right? All you have to do is invest in the best performing sector each year and simply walk away. Unfortunately, it is not that easy, nor are we advocating that you try to pick the absolute best performing sector and put all your eggs in one basket; rather, this is simply a powerful illustration of just how important incorporating a sector rotation plan can be into your overall portfolio strategy.

Total Return Table


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