Gavekal Capital: Correct Sector Allocation Unlocks The Power Of Compounding

Tuesday, January 27, 2015

Correct Sector Allocation Unlocks The Power Of Compounding

We talk a lot about sector allocation. It is incredibly important for investors, especially over the long-term. The correct sector allocation can lead to massive outperformance while the wrong sector allocation significantly increases your career risk.

The MSCI World Index has gone from 912 to 1292 over the past four years, which is a 9.1% annualized gain. For comparison sake, the S&P 500 has managed an annualized gain of 9.6% since 1928. So from a historical sense, the previous four years of equity returns seem fairly normal.


However, if we dig below the index level slightly and look at returns by sector we see just how bifurcated this advance has become.On an equal-weighted basis, the health care industry has been by far and away the best performing sector. Health care has managed an incredible 26.5% annual gain over the past four years. It has outpaced the second best performing sector, consumer discretionary, by over 10% and has doubled the performance of the third best sector, information technology. Most remarkably, health care has managed to gain 26% more annually than the worst performing sector, energy, over the past four year.

MSCI World Annualized Return

But instead of focusing just on the best or worst performing sector, let's focus on the fourth and fifth best performing sectors. The consumer staples sector has delivered an annual return of 12.7% over the past four years. Meanwhile, industrials, the fifth best performing sector has delivered annual returns of 8.7%. A four percent annualized differences doesn't seem like that much. It even doesn't seem that important over a four year period. Over the past four years, consumer staples is 61% higher while industrials is up a still respectable 39%. However, let's extrapolate this out to 15 years. Let's consider a situation where both of these sectors deliver there exact same annualized rate of returns over the next 15 years and the average stock delivers its exact same annualized rate of return (10.6%).

In this hypothetical situation, if you correctly invest in the 4th best performing sector, instead of the fifth best performing sector, you end up with TWICE as much money. Over a 15 year period, industrials would return 249% and the consumer staples would return 501%. The average stock would return 353%. When it comes to wealth accumulation, sector allocation can make all the difference.