This commentary originally appeared Jan. 5 on ETF Profits - to access all the strategies from our team of ETF professionals, click here.
Last week, I wrote about asset allocation for this year. This week, I'd like to review last year's sector performances and remind readers that a prudent investor wants to have proper asset and sector allocations, instead of just picking individual stocks.
Last year was one we will not easily forget: volatility was very high and correlations among asset classes increased dramatically. The S&P 500 finished dead even -- you might as well have closed shop for the entire year and come back on Jan. 3, 2012.
Overall, the market did not trade on fundamentals but on macro and political events -- or as some people say, the market was not rational. To each his own, but most of us do the homework and analyze our investment picks, and we expect basic fundamental analysis to work. But the market did not behave rationally, and even hedge funds lost money in 2011. It is no wonder that a typical investor, even one who did his homework, did not fare well.
Let's look how the sectors performed for the year.
Source: The Rockledge Group
The top performing sectors were utilities, consumer staples and health care -- defensive sectors that outperform during sluggish economic and uncertain times, and 2011 was a good example. Although we usually speak of asset allocation, I would characterize last year's sector performance as "fear" allocation.
So, ask yourself if you would pick individual stocks in this "fear" market. I say absolutely not. The political and economic environments are highly uncertain, correlations have increased dramatically, and stock-picking did not prove to be a good investment approach in 2011. The more prudent approach is to find a diversified equity portfolio and focus on sectors.
If you look at the past six years, it is clear that each year brought its own market dynamics, and being in the right sector was crucial to good performance.
What this chart tells us is that each year, the performance difference between the highest- and lowest-performing sectors is typically very large. For the past five years, this sector dispersion has varied between 24% and 56%.
It is also well documented that more than 90% of an individual stock return can be attributed to the sector it's in. So if you were picking stocks in the lowest band of the sectors, it was virtually impossible to outperform, or even come close to, the S&P 500 benchmark, and your portfolio would have disastrous (relative or absolute) results.
On the other hand, if you had picked almost any stock from the highest band of sectors, you would have likely been an automatic winner every time.
My suggestion for improved risk-adjusted equity returns is to focus on sectors first, based on the fundamental and macroeconomic analysis, and invest in well-diversified corresponding exchange-traded funds. Adventurous investors can look within these sectors and drill further into industry groups or industries, or even sub-industries.
For the highest investment-risk-profile investor, perform the above analysis and then pick individual companies. Based on the past year and current year's uncertain economic and market environments, staying with an appropriate sector investment thesis is prudent.