Sector Risks in Mutual Funds - BlueCollarDollar.com

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"Mutual Funds for the Utterly Confused" (McGraw-HIll, December 2008)

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Sector Risks

At the beginning of the book I suggest that a bear market is the best time to talk about the fundamentals of investing. When these types of markets take hold, investors begin to rethink strategies, realign holdings and become more cautious and skeptical. When a bear market persist, we review the extreme elements of risk, the reason we are where we are right now.

Sector risk is a discussion about weight, sort of an investors food pyramid. We all know how the FDA looks at what we eat, creating a pyramid of foods that we need the most of making up the base and as you gradually climb move to the top of the pyramid, you have the foods we may have but should have in such moderation as to almost not bother.

I have two problems with the pyramid as an illustration: Our eyes always go to the top of the pyramid caring little about foundations and cornerstones, what gives the top its height and strength.

And because of that, we crave whatever resides up there more than we should. Where fats and oily foods take the top billing on the food pyramid, sector funds would be there for the investor pyramid.

Sector risk is real only if you have failed to rebalance or obtain any balance in your portfolio. Risk is needed to grow your money, but it should be measured. The savviest of investors have always built a foundation of conservative investments in their portfolios. This doesn't mean no risk, instead, it means risk that are so widely spread (the keyword is diverse) around the broader market as to not feel too much pain at once should the market falter.

According to paper published by Qing Li, Marisa Vassalou and Yuhang Xing in 2003, "The underlying idea is that various sectors of the economy may receive different productivity shocks that will result into different returns on capital for the firms of those sectors. The return on capital is directly related to equity returns, and in the context of business cycle models, the two notions are identical. But the return on capitalalso determines investments and as result, the investment growth of the sector."

The more specific a fund's offering becomes, the higher the risk for your investment dollar. Drilling down into a specific industry such as financials, commodities or real estate, to mention a few of the scorching hot sectors that have turned icy cold over the last fifteen months would have seen enormous returns (which attract numerous investors, lured in by the possibility fof out-sized gains).

Once again, risk is necessary but in measured doses. Although sector funds do offer some great opportunities if that sector takes off, they are best kept to less than ten-percent of your retirement portfolio. Outside of that, in a taxable portfolio, you may take a plunge of up to 25% if you spread the risk among numerous sectors.

Your eyes my look to the fatty foods at the top of the food pyramid for comfort but the overindulgence of them can lead to serious problems. Same applies to sector funds (much easier for many of us to access when they are sold as exchange-traded funds, priced throughout the day just like stocks). Moderation is always the wisest choice when it comes to risk. Too much never leads to long-term benefits.

Next up: small-cap investment risk