Yet More Reason to Diversify

 | Oct 21, 2013 | 9:00 AM EDT
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Thus far in the third-quarter earnings season, the telecom sector has led the way in terms of positive surprises, with a 100% track record. That's hard to beat!

But let's dissect what that really means. Essentially, it boils down to this: Verizon (V) beat.

Of course, AT&T (T) isn't due to report until Wednesday, and CenturyLink (CTL) not until November, but no matter. (Readers may discern an invisible "sarcasm" hash tag here.)

When a trader or investor believes a trend may be forming, the temptation to jump in can be great. That can be the case even when there are clearly not enough data points to form a viable trend. But, as the research of Nobel Prize winner Gene Fama bears out, it's impossible for active managers or traders to consistently predict which sector will outperform at any given time.

Obviously, earnings performance doesn't necessarily correlate exactly to sector strength at any given time. Year-to-date, healthcare is the leading sector, while telecom languishes near the bottom.

Just as returns among equity markets, fixed-income markets and asset classes are random, so are sector returns. If you look at a chart of sector performance between 1998 and 2012, as I have done, you'll see there is no discernable pattern when it comes to returns.

I recently spoke to a local chapter of the American Association of Individual Investors. These local groups are barraged with guest speakers demonstrating trading software and newsletters, all touting their product's ability to help the do-it-yourselfer "beat the market." Generally, that means the S&P 500. But is that always the appropriate benchmark? It's not uncommon to see traders with "systems" that beat the S&P with some level of consistency.

But contrary to what most Americans have been led to believe, the market does not consist solely of the S&P, and the S&P is not the appropriate benchmark for other asset classes.

For example, if you are trading commodities, wouldn't a better benchmark be the Goldman Sachs Commodity Index? If you are aggressively trading small-caps, then compare your performance with that of the Russell 2000.

Small-caps and value stocks consistently beat large-caps and growth names over multiyear time frames. So it's really not a stretch at all for small-cap and value managers and traders to drum up statistics of how they beat the S&P 500. Yet you see that comparison made all the time, mostly because the overall investing and trading public isn't fully informed about the most appropriate benchmark comparisons.

The truth is: Various asset classes, market capitalization levels and sectors turn in differing performances over time. But you can't tell in advance which will lead or lag in any given moment. That bolsters the case for broad diversification throughout your portfolio.

That brings me back to the idea of sector performance. Plenty of people believe they have some special insight into how a particular corner of the market will behave. Maybe it's an article they read, a stock screen they ran, or somebody they saw on TV. It doesn't matter.  But opinions are just opinions. They don't hold a candle to actual data.

In 2011, energy was up 13.39%, making it the second-best performing sector. In 2012, it notched a gain of 10.08%. That's hardly disastrous, but it still puts the sector second from the bottom. In many years, not all equity sectors move in tandem -- some have shown gains while others have shown losses. In recent years, 1998, 1999, 2000, 2001, 2005, 2007 and 2011 provide examples of that situation.

Unfortunately for traders and investors who believe they have an ironclad argument when it comes to picking sector strength, the data don't support that case.

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