A key to weathering – and potentially profiting from – a market correction is planning and implementation.
Rotating Sectors: Diversification With a Tilt
Portfolio diversification suggests that you would have adequate exposure to multiple sectors at the same time. However, it’s highly unlikely that all stock sectors will perform equally the same at the same time. Some invariably will do better than others.
A sector rotation strategy would be one way to act on that. The goal, quite simply, is to invest more heavily in sectors that you expect will outperform other sectors over some period of time. Conversely, you would reduce your exposure to sectors that you don’t think will perform well.
You can invest directly into sectors by purchasing sector mutual funds or exchange-traded funds (ETFs). You should recognize that if you follow a sector rotation strategy, you will be concentrated in some sectors, which increases your overall portfolio risk because of reduced diversification.
A sector is made up of a broad group of related industries. And, of course, each industry includes many companies. Although there isn’t a single, unified definition of each sector, most lists include the following:
- Consumer Discretionary
- Consumer Staples
- Information Technology
- Telecommunication Services
Diversification and Asset Allocation
At its core, sector rotation is an overweighting strategy. But while you might give up diversification, you can still maintain your desired asset allocation approach for your portfolio. For example, if your asset allocation plan calls for 50 percent of your portfolio in stocks, you can keep that same percentage allocation under a sector rotation strategy.
“With sector rotation, you can still be diversified while maintaining your desired asset allocation,” said Brian Bachelier, vice president of active trader strategy at Scottrade.
Scottrade clients can use the Portfolio Review Tool to find both their broad asset allocation mix and their sector weight. Traders can determine their sector exposure with the help of Sector Trends in ScottradeELITE®.
Sector Rotation Strategies
How do you determine which sectors to overweight and which ones to underweight? There are several tactics that you can consider.
- Seasonality. Certain sectors are thought to perform better during some parts of the year than others. Holiday shopping, for example, can influence and even create more volatility for some sectors.
- Economic cycle. The U.S. economy typically has a life cycle that begins with economic expansion and ends with a recession. As that cycle changes, certain sectors go in and out of favor.
- Momentum. Sectors can have strong performances that last months or years. Investing in already hot sectors that you think can continue to outperform is a classic momentum strategy.
- Market cycle. Separate from an economic cycle – although similar in nature – the market has its own cycles as indexes move from a market bottom at the end of a bear market to a market top, signifying the end of a bull market. Certain sectors can be in or out of favor depending on existing market cycle.
There certainly is no guarantee that any sector rotation strategy will work. You should be aware that the performance of a sector can change unexpectedly and quickly.
What sectors do you think might outperform over the next few months?
Diversification may help spread risk it does not assure a profit, or protect against loss, in a down market.
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