Why Picking the Winning Sector Is a Losing Game

Wealthfront clients are generally well aware of best practices for building wealth and a retirement nest egg. The holy grail consists of broad diversification, indexing, minimizing costs and taxes, rebalancing, and staying the course (all of which are key tenets of Wealthfront’s investment philosophy). But equally important is to avoid the common mistakes that have crushed even the best-laid investment plans. Among the worst mistakes is to get swept up in either extreme euphoria or in waves of unrelenting pessimism, both when it comes to the market as a whole and the performance of specific sectors. It is this tendency that has prevented many investors from realizing the generous long-run returns from common stocks and has led to devastating losses. 

Since 1926, the rate of return of diversified portfolios of common stocks (as measured by the cap-weighted average return of stocks listed on the NYSE, AMEX, or NASDAQ exchanges) has been about 9 to 10 percent per year (5 to 7 percent after inflation). But one has a better chance of earning those returns by buying and then holding on for long periods of time, both in good times and in turbulent ones. If you buy only during the times when prices are rising, and if you tend to do some selling during periods like the COVID pandemic and the global financial crisis of 2007, when prices are falling, your rate of return is likely to be far worse. DALBAR Associates has calculated that mutual fund investors have actually realized rates of return that are 5.5 percentage points lower than the published returns of the S&P 500 due to this error. Their annual Quantitative Analysis of Investor Behavior consistently shows that bad timing can be very costly, and managing your emotional behavior is essential to prevent you from acting imprudently.

DALBAR’s findings point to this broad phenomenon, but an actual example from recent history demonstrates how investors can make serious mistakes even when involved in the most successful economic sectors. The ARK Innovation Fund (ARKK) is a popular technology-focused ETF that invests in companies at the leading edge of “disruptive” technological innovation such as artificial intelligence. In early 2020, the fund was quite small, and few individuals were investing in new shares. The ETF sold at about $50 a share. But ARKK’s price began to rise sharply with the success of new technology companies, and as media publicity extolled the enormous promise of artificial intelligence. By early 2021 the fund sold at over $130 a share. Investors were pouring several billion dollars per month into the fund. It was when ARKK prices were at their peak and enthusiasm was contagious that money flooded in. 

The chart below illustrates this phenomenon by plotting the price of ARKK against the fund’s inflows and outflows over time. (ARKK has paid $1.14 in dividends since January 2021, but this is insignificant compared to the price decrease since then.)

As you can see, enthusiasm eventually crested. By April 2022, ARKK’s price fell back to around  $47, and it remains close to that price even today. As the overexuberance faded, investors withdrew their funds, and since July 2022, many millions of dollars have been redeemed from ARKK. The money rushed into the fund during the period of peak prices, and came out after a precipitous decline. From the end of December 2020 when inflows were at their peak, through the end of June 2024, the price of a share of ARKK has declined by over 64%. Even when new technologies are transformative and real, emotions leading to extreme optimism and pessimism can contribute to enormous investment losses. As the ARKK example demonstrates, even when investors correctly pick a high-performing sector, timing errors can lead to negative returns.

This behavior is not specific to ARKK. The same pattern can be seen when looking at inflows and returns in other tech sector ETFs over time, like the SPDR S&P Kensho New Economies Composite ETF (known as KOMP). KOMP seeks to track innovative technology companies, with a focus on those using artificial intelligence, automation, and robotics. For most of the time from its inception in late 2018 leading up to 2021, a share of KOMP cost under $40. However, as the chart below shows, KOMP’s price shot up to $67 in early 2021 and net inflows peaked in mid 2021, when the price of a share of the fund was over $65. Currently, the price is back to about $45 and net inflows are very small. If you bought KOMP near the peak, as many people did, your investment is worth much less today. From the end of June 2021, when inflows peaked, to the end of June 2024, the price of a share of KOMP has declined 31%. 

The examples above clearly illustrate that trying to time when to get into the market can do more harm than good, and in many cases trying to time purchases and sales can lead to disappointing results. 

But the same conclusion holds for trying to pick the best sectors to invest in. At the start of 2024 pundits were saying with absolute confidence (really overconfidence) that certain sectors would easily beat the market. Some touted oil stocks, others small cap stocks, and different experts “assured” us that tech stocks would either continue their upward rise or fall precipitously. We don’t recall anyone arguing that bank stocks or utilities (two of the best performing groups in 2024) would outperform. The basic lesson that investors must accept is that it is just as impossible to consistently predict the best sectors or asset classes for investment as it is to time the market. Neither individuals nor professional experts are able to do it. That is why over 10- and 20-year periods, more than 90 percent of actively managed investment funds underperform low-cost, broad-based index funds.

The bottom line: Hold onto diversified index portfolios. Be cautious about trying to find the right time to sell or the best sectors. With broad-based index funds you can be sure that your portfolio will have meaningful exposure to those sectors producing the best returns. And consider the potential benefits of investing regularly over time. If markets do decline, as they invariably will in some periods, you will be buying more shares at lower prices. Even during the volatile first decades of the 2000s, when markets did not advance, steady investors made money because they were buying more of their shares at lower prices. So stay with a regular savings and investment plan. Continue to take advantage of lower costs and tax-loss harvesting, which are our preferred approach to building a retirement nest egg and accumulating wealth. And if you are “confident” that you know some low-cost stock that is bound to be a future AI winner, buy it as an addition to your diversified portfolio of index funds, not as a substitute. By doing so you will be taking some added risk, but assuming it’s a small percentage of your portfolio, you’re unlikely to dramatically increase your overall volatility. And the beauty of owning a broad index is that you’re likely to get exposure to that AI winner in your portfolio anyway.