It can be so tempting to dive into a part of the market that you think will soar based on some trend, an analyst's recommendation, or your gut. Morningstar isn't a fan of this kind of speculation, but if you must, do it sensibly. Reserve a very small slice of your portfolio-say 5% or less-for such activities and make sure the remainder of your portfolio is well-diversified and designed to meet your long-term investment goals with a level of risk that is acceptable to you. Finally, understand that when you speculate, you may be wrong-in other words, be prepared to lose that 5% of your portfolio.
We also recommend that you avoid buying a fund that's already hot. Investors who fall prey to that temptation often miss out on some great returns from underappreciated funds. If a fund is hot enough to catch investors' attention, many of its holdings may sport tremendously high price multiples. Investors chasing such hot funds can wind up losing money when the companies they hold fail to live up to the lofty expectations embedded in their prices.
Take T. Rowe Price Media & Telecom (PRMTX), a topnotch sector fund. The offering boasted fantastic returns when the communications frenzy took hold in the late 1990s, posting a 93% gain in 1999. Investors loved the sector and they hopped on board just in time to spend the next three years in the red. It's worth pointing out, of course, that the fund continues to impress-at least on a relative basis. It may lose a lot of money from time to time (such as 2008, when the fund lost 46% compared with the S&P 500's 37% decline), but it generally outpaces its industry rivals nicely, and is at the top of its category over the trailing 5- and 10-year period.
If you can't resist the temptation to bet on a sector, though, do one of two things: Either play long-term trends (the aging of the baby boomers and increased demand for health care is one such trend) and dollar-cost average (invest a set dollar amount each month) into your sector fund, or make a bet on an out-of-favor sector, particularly one that most other fund investors are avoiding. Because the average investor doesn't have such good timing, you can often outperform by buying what most investors are selling. We'll explore this strategy in a later lesson.
A Few More Questions >>