4 Rules for Sector-Fund Investing

Hold it right there! If you're about to reach for the phone and allocate some of your precious money to a sector fund, make sure you've followed these four basic rules.

1. You know the sector: You have been following that particular industry sector very closely and have good reason to believe that companies within that industry are going to experience a large growth spurt relative to the rest of the market.

Q: What are sector funds?
A: Mutual funds that concentrate on a particular industry or part of the economy, such as technology, banking, health care or oil
Tip: Keep your sector funds in a tax-deferred account

2. You are planning to defer taxes on the gains: Most sector funds are very actively managed. That means the pros who run them are watching their industries closely and buying stocks that are pulling ahead of the pack and selling stocks that are lagging. All this buying and selling activity is great because it helps to generate profits. But remember, those profits are taxable. So, for example, the five-year average return of the Fidelity Select Technology fund, as of November 2000, was 27.86 percent. But adjusted for taxes, that return would only be 21.56 percent. (Yes, you got it: a full 6 percent of the money the fund made for you would be lost to taxes.) The moral of the story? House your sector-fund investments inside a tax-deferred account such as a Roth IRA or your 401(k) plan.

3. You limit your investment: Sector funds tend to boom and bust with their industries. Therefore, put only 10 to 15 percent of your investments in a specialized sector fund. This will protect you from sudden industry downturns. To be sure your investment portfolio is well diversified -- and therefore not exposing you to too much downside risk in one particular industry -- you should buy a sector fund only after you have already bought stocks or funds that represent a large cross section of the economy.

4. You’re ready to rock 'n' roll: Entire industries can boom or bust because of changes in the world and local economy, interest rates or government regulation. The highs can be stupendous, but the lows can be stupefying. For a prime example, take the Fidelity Select Technology mutual fund, which specializes in technology stocks, such as companies that make computer hardware and software. The fund gained a mind-boggling 74.2 percent in 1998 compared with 1997 and a whopping 131.7 percent in 1999. However, it came crashing down with the entire technology sector in 2000, losing 32.5 percent. By contrast, the Standard & Poor's 500 Index -- which tracks the stock-market performance of 500 top U.S. companies and is therefore far more diversified -- did not rise as much or fall as hard. This means that if you had invested in January 2000, joining the now-sorry crowd of people who chased hot returns, you would have lost about a third of your money. Of course, your investment would have held up very well if you’d held it for the past five or ten years. In, fact, given the strong gains of 1998 and 1999, you would likely to be still giddy with your good fortune.

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