The Long Run: Use Sector Funds to Diversify, Not Gamble

The beauty of these portfolios, Ibbotson notes, is that individuals can utilize sector funds and the additional benefits they can offer without having to get tangled up in market timing. The sector holding are designed to remain static -- and rebalanced, of course, on a periodic basis. "By using sectors in this way, investors can add a dynamic twist to the traditional buy-and-hold portfolio," Majeski said. The study was commissioned by Invesco Funds.

Real World Problems

This portfolio poses challenges to individual investors, of course. Namely, it isn't very easy to build a portfolio with as many as 13 categories when the minimum investment for many funds is as much as $3,000.

"It is a lot easier for someone with $100,000 to invest," Majeski acknowledges. "But a person can make simple adjustments to approximate this portfolio successfully."

For instance, instead of buying a large-cap growth and large-cap stock fund, an individual can buy just one fund covering large-cap stocks. Why? The correlation between large-cap value and large-cap growth funds is 96%, meaning they move in tandem consistently. (Given that large-cap value looks poised to outperformed growth over the next 20 years, according to Bear Stearns Asset Management's James O'Shaughnessy and others, I'd suggest choosing a large-cap fund that skews more toward value.) Likewise, one can pick a top-performing fund that focuses on small- and mid-cap stocks.

Another key factor: Because this asset allocation model is based on as many as 13 categories, make sure you are buying funds that live up to their name. Many funds that call themselves value funds actually are growth sector funds, such as the Goldman Sachs Internet Tollkeeper, which invests in a broad array of sectors. Know what you're buying.

Also, investors should note that this asset allocation model includes overseas funds -- overseas exposure, whether from a global fund or an overseas fund, is still a vital component of diversification. If you own a great Asian fund such as (MCHFX)Matthews China, for instance, you don't want to sell it. Simply check out Morningstar's Portfolio X-Ray and examine how the overseas funds affect your overall sector and capitalization allocations.

Now, investors need to figure out which are the best funds in each category to buy. Each week, TheStreet.com offers a Five Funds column highlighting outstanding offerings in each category. Check it out. In coming weeks, we'll also focus on top-notch sector funds.

So far in the Long Run's Asset Allocation series, we've discussed the Portfolio Pitfalls and the Seven Pillars of Asset Allocation Wisdom. We have also discussed the benefits and detriments of lifestyle funds, and now using sector funds to improve your portfolio. This week, we'll continue our focus on fixing your asset allocation, including a look at how investors can use funds that use short-selling can bring balance to a portfolio.

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