"I can't believe I ate the whole thing!"

Forty+ years ago, an advertising campaign for Alka-Seltzer featured that lament from a man who had overeaten, was suffering from indigestion, and couldn't sleep. The phrase entered the popular culture, and was soon repeated at dinner tables across America. Sometimes we can have too much of a good thing, and although the experience may be enjoyable while it lasts, we later wonder "what was I thinking?"

After an investment (or investing strategy) has a great run of success, investors can be tempted to "overindulge." They take money away from other investments in order to double or triple their commitment to what almost seems like a sure thing. But it's never a sure thing, at least not in every environment. There will come a time when the investment underperforms, perhaps dramatically. And investors are left with financial indigestion, complaining "I can't believe I invested that much!"

SMI's Sector Rotation strategy may be tempting you to load up on the recommended fund of the moment. As we point out in the February issue (coming on Wednesday):

For the third year in a row, SR posted an extremely strong gain, following 2013’s breathtaking +65.7% rise with another +49.9% in 2014. (Just for fun, an SMI reader who had $10,000 invested in SR last year made a profit of $4,990. That’s $3,719 more than “the market” gained—enough to pay the extra $5/month cost of a premium membership for the next 62 years!)

SMI readers who have followed this strategy over the past 10 years have earned a total return of +430%! (Those aren’t hypothetical results. This strategy has been active since late 2003.) Such performance is incredible.

However, in the same article, we go on to emphasize: "You need to be aware of the significant degree of risk and limit your exposure appropriately. SR is great when it’s soaring, but it occasionally makes equally dramatic moves to the downside."

I thought it might be helpful to expand on that warning a bit with some historical data. I've gone back to take a look at the outcomes from Sector Rotation for various "rolling periods" of the past 15 years. After looking at the results from buying on January 1, 2000 and holding for 12 months, I then “rolled” to the next month to see what happened if the fund had been purchased on February 1, 2000 and held for 12 months. Then I moved to March 1 and did the same thing. And so on. Continuing in this way, I computed the results for a total of 169 different 12-month holding periods. This is in contrast to only 15 such periods when calendar years are examined. Using this more exhaustive process provides a better picture of the degree of volatility and level of returns that may be expected from an investment.

The table below shows the annualized results from testing 12-, 24-, 36-, 48-, and 60-month holding periods.

 
Sector Rotation 2000-2014 12 Months 24 Months 36 Months 48 Months 60 Months
Average Annualized +18.4% +16.1% +14.8% +14.2% +13.4%
Best Case Annualized +84.3% +57.6% +46.8% +35.2% +31.7%
Worst Case Annualized -38.6% -19.7% -13.8% -4.9% -0.8%
Worst Case Non-Annualized -38.6% -35.5% -36.0% -18.1% -4.1%

 

The top two lines are the encouraging ones. What's not to like about a strategy that, on average, returned +18.4% every 12 months? Or that once turned in an annualized return of +31.7% every 12 months for 60 months?

But the point of this exercise is not to focus on all that can go right with SR, but rather on what has occasionally gone wrong. The numbers in the "worst case annualized" row don't look too terrifying (other than that 12-month loss). You may think, "Sure, I could handle a -13.8% loss over three years. Disappointing to lose, but that's not a huge loss."

That's the problem with looking at annualized data. We tend to focus on the number rather than the word "annualized." In reality what the table shows is that, in that worst-case instance for a 36-month period, the strategy lost -13.8% each year for three years. That translates into a cumulative loss of 36%.

After faithfully following the strategy every month for three years, you find you've lost more than one-third of your beginning capital! That kind of consistent losing pattern is enough to push most investors to the sidelines. Which would be too bad.

The 48- and 60-month non-annualized numbers show that SR tends to make money in years four and five after a disastrous start. The investor would have regained all but about 4% of the lost capital. But not if they bailed out after those first three discouraging years.

I want to leave you with these takeaways: (1) Be balanced. Don't overcommit to SR just because it's been great in recent years. (2) Be realistic. Expect some occasionally dramatic losses along the way. (3) Be committed. If you're going to start this particular journey, stay in for the long haul.