Ignore the Siren's Song of Sector Funds

To date, the market has been up nicely. Wall Street is euphorically predicting that we're now in a new bull market. Such euphoria worries me. Some of the same stock market gurus who were thoroughly discredited during the market collapse are back singing, "Happy days are here again." They were spectacularly wrong in early 2000, at the peak of the market, and they're saying almost the same things again.

Whether we're in a new bull market or not, as always, Wall Street is not about to learn anything from history. Since we're likely to see a replay of all the fads and dangerous investment advice from the past in the next few years, it will be physician-investors' responsibility to keep their heads straight and not fall for them all over again.

Sector Sales Pitches

Sector fund investing is a fad gaining fast allegiance again. They invest in stocks of specific industries (eg, technology, energy, etc). Right off the bat, the concept of sector funds is antithetical to 1 of the basic tenets of investing—that you should diversify broadly. They are sold to investors with 2 different sales pitches.

The first pitch relies on the fact that in any market a few sectors always do much better than the general market and other sectors. If you pick up a list of the best-performing funds for any short period, most likely, a few sector funds will be at or near the top, often outdistancing the other funds and the market by miles.

In retrospect, it always seems obvious why the particular sector did well over that period. It takes only a little self-deception to believe that if you had paid attention, you could have foreseen 6 months back which sector would flourish over the next 6 months.

So the first sales pitch you will hear is that you or your guru can predict which sector will do well next and, therefore, you should invest in it to do better than the market. Some gurus will give you the sage advice that you should pick 2 or 3 sectors instead of just 1 in case you, or they, are wrong about 1 of them.

The second sales pitch relies on broad diversifying. Investing in a broadly diversified index fund, the claim goes, is only for the amateur investors. You should be able to do much better by creating a broadly diversified portfolio, combining the best sector funds in the different industries. That way you can take advantage of the best industry experts and you can also vary the weights of the different sectors in your portfolio to take advantage of where we are in the economic cycle.

Repetitious Mistakes

If you fall for either of these sales pitches, you're repeating what happened last time. A few sector funds almost always show up near the top of the worst-performing funds for any past period. No one can predict consistently and ahead of time what sector funds will do better than the others in the next 3, 6, or 12 months. When you buy sector funds, you're taking on enormous risks and earning a commensurate return only if you're lucky. You can't base investment decisions on anticipated luck.

How about the diversification pitch? Since sector funds often have high costs, it's an expensive way to create a diversified portfolio. Likely, once you get into such slicing and dicing of the market, you will trade in and out often and won't really have a diversified portfolio. You will only enrich your fund company.

Whether we're in a new bull market or not, resist the siren's song of sector funds. Pour wax in your ears if that's what it takes.

Chandan Sengupta, author of The Only Proven Road to Investment Success (John Wiley; 2002), currently teaches finance at the Fordham University Graduate School of Business and consults with individuals on financial planning and investment management. He welcomes questions or comments at chandansen@aol.com.