Beware Betting Too Heavily on Hot Sectors

If you’ve lost a lot of your nest egg in the last two years and you’re desperate to rebuild it, you may be tempted to go the Vegas route: “double down,” betting heavily on what you hope will be the stock market’s new leaders.

Most financial advisors say it’s a foolish move. But it’s easy to understand why some investors would consider it.

After all, technology stocks rode a nine-year cycle of superior performance through 1999 before they crashed. Couldn’t such sectors as smaller stocks or health-care issues, which have led the market over the last two years, be on their way toward similar performance streaks?

It’s possible, experts say. But they note that the duration of sector trends is always hard to predict. You could be investing heavily just before a sector peaks--as many investors did with tech stocks in the first quarter of 2000.

“Almost every stock is cyclical in some way,” said Sam Stovall, a strategist at Standard & Poor’s in New York. “To paraphrase Andy Warhol, they all have their 15 minutes--or 15 months--of fame and then fade away, because you can’t have accelerating fundamentals and [stock] valuations forever.”

William Barrett, head of the Los Angeles office of Fiduciary Trust International of California, which manages institutional and high-net-worth accounts, said gold-mining and defense stocks, for instance, have been benefiting from trends that should not be construed as permanent.

“The flight to security and quality is probably a short-term reaction to everything that’s going on in the world. People rush into defense stocks and the gold sector out of fear, but eventually those sectors will rise to a certain level and get overpriced,” Barrett said.

For long-term investors, diversification, rather than concentrated market bets, always will be the soundest strategy for generating wealth, said Paul Merriman, head of Seattle-based Merriman Capital Management and editor of the newsletter FundAdvice.com.

“When you’re betting big you’re into speculating, not investing,” Merriman said. “You’re like a guy at the horse races who has a bad day, then bets it all on a longshot in the last race, hoping to get even. He is probably going to leave the track broke.”

The strong performance of gold this year exemplifies the point, Merriman said: “Where were all the people saying that gold is going to make this tremendous move? The truth is, they’ve been saying it forever, and only now they can say, ‘I told you so.’ ”

Merriman believes that strategies based on market timing and stock-sector rotation can work, but only for active traders who monitor their portfolios daily or weekly.

Even so, he said, “I would never have that much confidence about industries as a buy-and-hold thing, but the major asset classes like small-cap and value have a reasonable chance of continuing to outperform.”

He believes that modestly over-weighting small-cap and value stocks or funds in a portfolio can make sense, because historically they have outperformed large-cap and growth stocks over long periods.

Some stock sectors attract almost universal acclaim today--for example, industries that could benefit long term from an aging population.

“Over the next 15 years, if you use demographics as your compass, it points to opportunities for health care and finance,” Stovall said. “Health care because the biggest population growth is going to come among those age 50 and up, and they will have plenty of aches, pains and serious illnesses; finance because people are retiring and they’re going to look at their portfolios and say, ‘I need some help here!’ ”

But within those sectors some companies will benefit more and some will benefit less. If you, or your sector-fund manager, pick the wrong companies, your returns could be dismal.

Stovall is wary of the drug industry in the near term, for example, because generic drugs, uncertain product pipelines and a tougher Food and Drug Administration are weighing on many key companies, he said.

Will Muggia, co-manager of the Touchstone Emerging Growth fund, agreed, saying that although he likes health care, it’s “important to pick your spots.” Along with HMO stocks, he likes orthopedic-device makers, whose sales are improving and could continue to benefit from the demographic tailwind, he said.