Despite rallying markets, affluent investors are still pessimistic about stocks. So what should advisors tell clients who are frightened of volatility and clinging to a hefty cash cushion?

Sam Stovall, chief investment strategist at Standard & Poor's suggests the following for boosting risk-adjusted returns in U.S. large cap stocks: Pick three sectors that represent totally different phases of the economic cycle, buy them in equal thirds, and rebalance annually. But not just any three sectors. Stovall recommends technology, energy and consumer staples.

In spite of the tech wreck of 2000, Stovall says that tech is still the best performing S&P sector over the last 20 years. Tech stocks notched gains of 545% between 1990 and May 20, 2011, compared with gains of 277% for the broader index.

For clients who object to tech's volatility, the consumer staples sector balances the portfolio with defensive qualities. Meanwhile, energy smooths the volatility out thanks to its low correlation. "This gives you both a higher return and lower volatility than tech alone," Stovall says. "So you're getting something for nothing — meaning higher return and the nothing is lower volatility."

Stovall back tested the combination to 1990, and found that it beat the broader index two out of three years, or 67% of the time, on average. So far this year, it's working. Through May 20, the S&P 500 had gained 6%, while the combination had gained 7.3%, with staples leading the way with gains of 9.5%: energy up 9.2% and tech rising to 3.2%. "If you really can't figure out the market, don't try, but by eliminating those sectors you don't need, you can improve your overall results," Stovall says.

While Stovall admits that at first blush, the three sectors look heavily concentrated, he says that it is very well-diversified. "True diversification comes from allocating among sectors with low correlations," he says.

Stovall says that tech performs best early in an economic cycle; energy is a late cycle performer, and consumer staples is a defensive sector that works in a recession. "When the going gets tough, the tough go eating, smoking and drinking," he says. However, he Stovall warns that this approach should not be used in place of a diversified portfolio.

Brian Gendreau, market strategist with Financial Network, and Michael Rawson, ETF analyst at Morningstar both agreed that Stovall's theory was fundamentally sound, but noted that they would probably still want to add a few more sectors. "I think what he's saying is right. My only qualm is why stop there?" Gendreau says. "You could do six sectors. Industrials and tech are both cyclical, energy and materials are both commodity plays, and consumer staples and healthcare are defensive plays, so you'd get even more diversification if you did that along the same lines."

Rawson notes that the large caps of the S&P 500 did well in the late 1990s, but that in the last decade, they were outperformed by small- and mid-caps. "If you bought a broad stock market fund or ETF and combined it with a bond fund, 60% equity, 40% in bonds, you'd probably get even better risk-adjusted returns than equity alone," Rawson says.

For a broader equity tracker, Rawson suggests the Vanguard Total Stock Market ETF, which costs seven basis points, and for bond exposure, he recommends Vanguard's Total Bond Market ETF, which costs 11 basis points.

Putting it to The Test

Rawson later analyzed Stovall's strategy and found that from a total return perspective, it "soundly beat" his 60/40, stock/bond portfolio. But, on a risk-adjusted basis, it did not. "The risk-adjusted return was maximized as we add more to the bond component," Rawson wrote in an email. "[Stovall] picked three of the best returning sectors (out of 10 sectors, tech, energy and staples finished one, two, and four, respectively) with some of the lowest correlations. An even lower correlation could have been achieved had utilities been included, but utilities had very weak performance, so it would have dragged down the average." (Stovall says he did not include utilities because they are bought mainly for income, and are substitutes for bonds.

"There is a good fundamental rationale behind including those three sectors," Rawson wrote. "Tech spending is related to corporate investment, which should be lowly correlated with energy prices. During a recession, when both tech spending and oil prices fall, consumer staples should hold up better."

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