What is the appropriate role of Sound Mind Investing's Sector Rotation strategy within a reader portfolio? The general question on readers' minds seems to go like this: If a little SR is a good thing, wouldn't more SR be even better? Here's a quick summary of SR for those who aren't already familiar.

SR was introduced in 2003 and is a simple strategy that applies the Upgrading concept to "sector funds," which are narrowly focused funds that invest in specific slivers of the market. The strategy (as we've implemented it) owns only one sector fund at a time. It is characterized both by very strong returns (over the two decades of data we have on it) and very high volatility, meaning steep gains and losses are typical.

We have often cautioned that the strategy comes with "a strong warning label" and reiterated our standard advice that only a small portion of one's portfolio (no more than 20% of the portion designated for stocks) should be considered for such an aggressive approach. Given the past success of SR, however, some are wondering whether that "no more than 20%" advice is too conservative.

Younger readers have asked, "If I have a time frame of 20-30 years, why should I limit myself to such a small allocation to SR? I'm at an age where I can afford to take the additional risk." Our response is that's fine, assuming you can handle the risk emotionally. It's one thing to understand intellectually that periods of sudden or severe market periods will come along occasionally and then pass away, but while you're actually experiencing it and seeing your losses accumulate, it can be quite difficult to stay the course.

One helpful tool in evaluating the risks and rewards of SMI's Sector Rotation strategy is the SR Historical Research file, which offers some great data to ponder. At the top of the sheet, you'll find average and worst-case data from the past 24 years, broken down into a number of time periods. Spending some time carefully considering that summary data is worthwhile. Doing so will point out, for example, that while SR has averaged gains of 23.9% per year over the past 24 years, there was one harrowing 3-month period when it fell a shocking 37.9%.

(For reference, Upgrading fell just 17.1% during those same three months, while Dynamic Asset Allocation lost only 2.7%. It's easy to underestimate the difference in risk profiles between Upgrading and SR, simply because both are considerably more risky than DAA. But there's a huge difference between Upgrading and SR, especially at the short-end of the spectrum. For example, since 1996, Upgrading has lost more than 20% in a 3-month period only three times: the periods ended 10/08, 11/08, and 12/08 (which was really one event). In contrast, SR lost more than 20% in a three-month period nine times: three times each in 1998, 2000, and 2008 (or three separate events). It's extreme short-term volatility like this that is truly terrifying to investors. Consider your reaction during the last bear market. Which did you find more frightening, the market's gradual 22% loss between Oct. 2007-Sept. 2008, or the 25% loss in nine trading days that followed? The market itself provided the answer: it was that nine-day span which triggered the panic. Shorter-term volatility is where Upgrading has had a significant edge over SR, despite the fact that their absolute single worst-case examples from the 2008 panic may mask that somewhat.)

It's important to stop at numbers like this and really ponder them to make them real. Think about working for years to accumulate a portfolio of $100,000 and then watching it shredded down to roughly $62,000 in less than 100 days. Gut wrenching.

Some readers will counter with the fact that they can handle a higher allocation based on the fact that they actually experienced that decline and were able, emotionally, to stay the course. That's a valid point, as many of the "worst" numbers listed on the sheet came from periods ended in late 2008 or early 2009. That fact does carry some weight: we're less concerned about experienced readers (who have had significant investments in SR over the years) raising their allocations. The ones that concern us more are those readers for whom these worst-case scenarios are simply an abstraction — just numbers on a page — particularly as the last bear market gets further in the rear view mirror.

Experienced or not, we would encourage any reader thinking of boosting their SR exposure to go back and relive once again what late 2008 actually felt like. Don't gloss it over. Another useful step is to scroll down the 3-month column in the historical research file and note all of the times when SR dropped by double-digit percentages in such a short period of time. That level of loss isn't a particularly unusual event in SR. In fact, we went through it again recently when SR dropped almost 20% in only nine trading days at the beginning of October. Yes, it came back almost as quickly...this time. But those are scary drops.

Keep in mind that it's one thing to see these numbers on a spreadsheet when you know the happy ending that followed; it's quite another to deal with losses of that magnitude "in the moment" when there's bad news blaring everywhere you turn and your portfolio has just lost a year or two's worth of gains in a matter of weeks.

It's also important to recognize the limitations of the data we have on SR. Sector funds have only been around in any kind of numbers for about 25 years, so that's as far back as our research can look. There are several problems with that, most notably the fact that we have no assurances that the next 25 years will look anything like the past 25. It's also important to recognize that with such a small sample size, the overall data can be skewed by a single unusual result. For example, in 1999, amidst the blow-off top of one of the market's most speculative episodes ever (the technology bubble), SR had an unbelievably profitable trade in a technology fund. We may never see another like it in our lifetime, as this single trade gained 275% for the strategy in less than two years. (Compare that to the still impressive 115% gain over the two years in our recently completed biotech trade — that tech trade was more than twice as profitable!)

At the top of the historical research file, we've included a second set of summary data (in yellow) to try to illustrate the somewhat distorting impact of this single trade. That yellow section of the file shows all of the summary data with 1999 excluded. The difference is significant. Excluding that single year from our 24-year period drops the average annual return from 23.9% to 18.5%. Still incredible, but it's clear how much those occasional huge winners have contributed. And while the average gains come down markedly, note that the worst case numbers don't change at all, as most of the "worst case" periods occurred later. The point is simply that the gaudy average returns from SR are significantly enhanced relative to what they would have been without that blow-off top in technology stocks.

So while those gaudy returns are accurate — they're the real historical data — the question is whether we can realistically expect that sort of boost from time to time. Because that's really what matters for our planning purposes, isn't it? Even without those 1999 returns, SR still has fantastic results. But they aren't quite as incredible, while the strategy retains the same high-risk profile. That may cause some readers to pause when considering a significant boost to their SR allocation.

To recap, SR is a great Sound Mind Investing strategy. I'm certainly not intending to make it seem otherwise. (I've had roughly 20% of my personal portfolio invested in it in recent years, for whatever that's worth.) But it's like a great power tool — it can be incredibly helpful if used correctly, yet dangerous in the wrong hands or if used incorrectly. The not-more-than-20% guideline we encourage is sufficient protection for most readers to not become unduly concerned by the short-term fluctuations SR funds regularly experience. Boosting your allocation beyond that level should only be done with great forethought about your own ability to handle the emotional ups and downs. This is no small matter, as it is the emotional side of investing that is most commonly an investor's undoing.

Experienced readers who have lived with the ups and downs of SR for some time may reasonably consider boosting their allocations to the higher end of this 0%-20% range. As for tinkering with the actual implementation of SR, we advise against it. Naturally, you're always welcome to do what you want with your portfolio. (We're big on individual responsibility around here, and give you the tools you need to adjust our strategies and recommendations to your personal liking. Of course, we also expect you to own the results — for better or worse.) The thing about a strategy like SR, or any other form of Upgrading, is it often forces you to make moves that are counter-intuitive. It's easy for many of us veterans to point to times when following a hunch outside the system's design would have paid off. It's much easier to forget all the other times when such a move would have been counterproductive. That's just the way humans are wired, which is precisely why SMI relies on mechanical, accountable systems. Given that, ideas such as "adding a second holding" may be great ideas, or they may not. We haven't tested them, and until we do, we're not inclined to encourage anyone to start playing by different rules.

One final bit of wisdom from a comment a reader once left in a discussion about SR:

[Regarding boosting the SR allocation]..."I felt the same way once. Now that I don't have 20 years left to retire, I'm thinking that I should have listened more to the person who told me that if I started investing early enough, I wouldn't need to take much risk to reach my goals. It's about taking as little risk as possible to reach your goals. Of course, feel free to swing for the fences, but if you don't have to risk it, why do it? At some time in your life, you might have enough $ that you don't feel like putting such a high % in this strategy b/c you won't sleep at night when it drops 30% in 3 weeks and your wife will wonder why you are suddenly glued to the computer watching your portfolio everyday. Then, your money draws more attention than God and His Word."
Well said.