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Weigh the potential for financial, materials and energy groups and how they will fare against the overall market in the next year (Matthew Sherwood For The Globe and Mail)
Weigh the potential for financial, materials and energy groups and how they will fare against the overall market in the next year (Matthew Sherwood For The Globe and Mail)


To ease portfolio decisions, focus on these three sectors Add to ...

Are you sick of trying to pick the stock that will outperform the Toronto equity market? Are you bored just buying an index fund?

By making three relatively simple decisions, you can significantly increase your chances of beating the market without spending an endless amount of time evaluating individual stocks.

Start by looking at the three largest subgroups of the Toronto market – financial, energy and materials stocks. As of the end of June, these three sectors represented almost 73 per cent of the index.

Now examine each of these three sectors and ask yourself if it is likely to do better than the market or worse over the next year.

Then use exchange-traded funds, or ETFs, that track these sectors to tilt your portfolio toward the one or two areas you think most promising.

Choose well and you substantially boost your odds of beating the market.

Over the year to the end of June, the TSX composite produced a total return of almost 8 per cent, while the energy sub-index was up 9 per cent, the materials sector lost 27 per cent and the financial sector advanced 17 per cent. If you had been only in financial stocks, you would have more than doubled the overall market performance. You would also have beaten the market if you had stuck to the energy sector.

To be sure, if you had chosen to be only in the materials sector, you would be panicking at this time. That underlines the importance of picking your sectors wisely.

Both the materials and energy sectors are cyclical in nature, meaning they are more sensitive to world economic growth than the rest of the market. China and Japan are major consumers of commodities and as their economies expand and contract, the effect on commodity prices is dramatic.

The rule of thumb is that as world economic growth expands, commodity prices follow suit. (Although energy prices are a bit more complicated in that they are also affected by political unrest in the Middle East.)

That suggests a simple strategy: If you think the global economy is poised for strong growth, tilt your holdings toward materials and energy.

And if you have a more downbeat outlook?

Financial stocks also benefit from a stronger economy, but less so than the materials or energy sectors. In addition, financial stocks have a history of growing dividends and earnings over long periods of time without a lot of volatility. Bank stocks are typically the first sectors of the equity market to rebound after a serious prolonged recession. All of that makes them good candidates for more treacherous times.

My suggestion is that you hold all three sectors in your portfolio, but put a bit more of your money into the one or two sectors you think most likely to do well over the year ahead.

You can do so easily by using ETFs that track the sectors. The iShares ETF that tracks the Canadian financial sector goes by the ticker XFN. (The full name is the S&P/TSX Capped Financial Index Fund.) For materials, look to the ticker XMA (for Capped Materials Index Fund), and for energy, choose XEG (for Capped Energy Index Fund).

Just because this strategy seems simple in no way diminishes its effectiveness. Taking the complexity out of a decision makes it much easier to solve. By making fewer investment decisions, your probability of being correct increases proportionately.

Consider limiting your stock investment decisions to an assessment of the earnings and market outlook for the financial, materials and energy sectors. You will be surprised how easy your portfolio decisions become.

Peter McMurtry, CFA, lives in Ottawa and is a former fund manager.

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