The way stock market returns are typically reported — “The market was up 12.7% last year” — masks the fact that at any point in time it’s normal for some stocks to be faring well while others are languishing.

Indexes such as the S&P 500 and Wilshire 5000 include the stocks of companies from every industry and segment of our economy and represent the general performance of “the market” as a whole. But hidden beneath the surface of the market’s overall performance there are strong cross-currents, driven by the action of the various industries that collectively make up the economy.

If it were obvious in advance which specific industries, or “sectors,” would enjoy the biggest gains over the next few years, there wouldn’t be any need to diversify. Real life, of course, isn’t so simple.

Because it is so difficult to predict which sectors will excel, most investors chart a conservative course of investing in mutual funds that spread their investments among most or all of the various sectors. Naturally, some of these diversified fund managers tilt their portfolios more heavily toward some sectors than others — often a key factor in determining which funds fare particularly well or poorly over a specific time period. (The fact that different managers in the same risk category allocate differently among sectors is one important reason why Upgrading has worked on an ongoing basis.) But the idea of diversified mutual funds is to spread risk by investing across the industry spectrum.

Some investors, however, want to target a portion of their investing toward specific industries. To do this, they rely on “sector” funds — or, increasingly, to indexed ETFs — that track the performance of specific sectors. These special-purpose stock funds limit their investing to a specific segment of the marketplace. Rather than gaining broad diversification, investors in sector funds buy into a non-diversified portfolio that restricts its reach to a particular industry or investing theme. When their particular industry is in favor, these funds really shine. But they have greater risk than diversified funds because when tough times hit the companies in the industry in which the fund specializes, the portfolio can’t be shifted to favor other types of companies. Because of their lack of flexibility, most sector funds carry higher risk than diversified funds.

The table below shows the average performance of the sector funds tracking several of the most prominent industry sectors over the past several years. The columns are color-coded to show at a glance how the performance of various sectors ebbs and flows in relative standing to each other. The final two columns on the right display the average performance of each sector over the entire period, as well as the risk taken to achieve that performance. The best performers appear at the top of each column and the worst at the bottom. (The relative-risk column is not sorted, but lower relative-risk scores are better. See How SMI's "Relative-Risk" Scores Alert You to Potential Losses for more information on this risk measure.)

(Click chart to enlarge)

The chart vividly illustrates the continually changing undercurrents flowing through the stock market. It’s common for one sector to be near the top of the group for a year or two, then be near the bottom soon after, and vice versa. In fact, that’s more the rule than the exception: in all but two years, at least one of the top three sectors followed its strong performance by landing among the bottom three sectors the very next year! It’s unusual for a single sector to stay “hot” for a lengthy period of time. In fact, this eight-year period never saw the same sector repeat as the top performer in consecutive years.

Unfortunately, many investors sabotage their long-term returns by buying hot sectors at high prices and selling them at low prices. The classic example of this was during the technology bubble at the end of the 1990s. Sure, some investors got in early and rode the technology investing wave all the way up. But many, many more didn’t buy tech stocks until late in the game, paying huge prices for stocks that were about to fall sharply.

That’s fairly typical. Investors repeatedly chase the latest trend, buying what’s been hot over the past few years. But as the table shows, when a particular sector has been hot for a few years already, it’s often about to slide to the back of the pack for awhile.

A better way to invest in sectors

Thankfully, should you desire to invest in sector funds, there’s a proven way to do so successfully. We’re referring to SMI’s Sector Rotation strategy, profiled last month in Sector Rotation Is Risky, but Highly Rewarding. If you’re not familiar with the strategy, read that article for a full explanation of how it works.

Here’s a quick summary: Each month, Sector Rotation ranks more than 100 sector funds using a modified version of our Upgrading momentum score. When we introduced the strategy more than a decade ago, we bought the top-rated fund and held it until it dropped out of the top 25% of our sector-fund universe. As soon as it did, we sold it and replaced it with the fund that was atop the SMI sector rankings at that time. Since then, we have continued this process of monthly monitoring and Upgrading as needed.

This Sector Rotation approach has been extremely successful, both in our backtesting from 1990 forward, as well as in our real-time application of the strategy since November 2003. It’s quite simple, requiring attention only once a month, yet it has produced exceptional returns. Sector Rotation, however, is sufficiently volatile that we caution readers to use it as an “add-on” (rather than core) strategy, limiting it to no more than 20% of your total stock allocation. (Sector Rotation is included as part of a premium SMI membership. Learn how Sector Rotation can give your portfolio a boost here.)

Conclusion

The main point to take away from this article is the value of diversification. Hitching your cart to one particular sector is usually a bad idea, resulting in frustration and subpar returns. In contrast, buying diversified mutual funds that invest across many sectors offers a convenient and effective way to greatly reduce volatility.

For the adventurous, however, sector investing provides an opportunity to earn outstanding returns. Still, even within a disciplined system such as SMI’s Sector Rotation strategy, significant losses will likely occur along the way, and you need to have the conviction to stick with the strategy at those times of maximum disappointment. If you can do that, allocating a small portion of your overall portfolio to sector investing through SMI’s Sector Rotation strategy can provide a powerful boost to your long-term investing results.