When the financial markets are extremely volatile traders can feel their stress levels rising. But there is no reason to be stressed if you are diversified. If a position turns into a losing one, but that position is only 10% of a well diversified timing portfolio, you will not feel the same as you would if it was your entire portfolio. Diversified portfolios are just as profitable, but you sleep better.

The current markets are quite volatile. Rallies lasting only days, followed immediately by sell-offs. Volatility is great if it is within a trend, but volatility that only moves the markets up and down quickly, within a sideways (trendless) trading range, can be quite unsettling.

Such markets are great for day traders, or should we say those who happen to be nimble enough to take quick profits. But for market timers and trend traders, the "lack" of a trend often results in small losses.

While no one wants to lose, we must keep things in perspective. Remember the saying, "keep your losses small, and let your profits run." That saying has been around for a long time for a good reason. There are times when you generate small losses, and that is just a fact of active market timing and in fact all trading.

We should not lose sight of the second part of the saying... "let your profits run." This is what all market timers look for. The next trend "is" around the corner. There is always another trend, and when it begins, the profits are made. There are powerful trends in progress right now! Look at the gold, the dollar and bonds.

Diversification Has A Place In All Portfolios

Remember that while very aggressive timing strategies do incredibly well over time, they can be frustrating over short time frames. During such times it is comforting to be at least somewhat diversified. We have spoken about and recommended diversification within timing strategies many times in this column. Believe me, it has its place in "your" timing portfolio.

If aggressive timing is causing you heartburn, try diversifying. One of the easiest ways to diversify, while still actively trading the markets, is to use sector funds. Let's take a look at the advantages of sector timing.

Trading The Sectors

How does a mutual fund market timer take advantage of volatility, while protecting himself or herself from the very real risks such volatility creates, as well as from the potential drawdowns that can occur during such times? The answer is by trading the sector funds. Here is a "quick" list of reasons why:

1. Diversification: By having small positions in multiple industries, you reduce exposure to any single industry being affected by a negative news event.

2. Volatility: While individual sectors are no less volatile than the rest of the market, they do not move together. So the volatility to one's portfolio is considerably reduced.

3. Drawdowns: Because sector funds go to cash during sell signals, and because there are always some funds in bull markets at the same time there are others in bear markets (during which those sectors are protected in money market funds), drawdowns are kept to extreme minimums.

4. Good in All Markets: There are always single industries in their own bull markets. Even during a cyclical bear market, such as we experienced during 2000-2002, there were always some industries moving higher. And if not, you are still protected by being in money market funds.

5. Active Timing: Though sector timing is not aggressive, it is certainly active. You will always be trading the bullish sectors, and exiting the under performing ones. In some respects, it is the equivalent of running your own well managed mutual fund.

6. Trends: Industry sectors tend to trend. And when they trend, they often move further (in either direction) than anyone expects. During a strong bull run, it is common to find individual sectors that double the gains of the overall market.

Winning The Battle

Even in volatile market conditions the Sector Timer strategy performs exceptionally well.

Because those industries which are poor performers will push their corresponding sector funds into cash positions, sector timing winds up with only the most bullish sectors actually invested. This is proactive money management at its best. Constantly putting your money in the strongest sectors while removing it from the weakest sectors.

This is where the diversity inherent in sector timing stands out. Top performing sectors are where your timing funds are allocated, and no one sector can cause irretrievable damage to the portfolio should that industry collapse without warning.

But most importantly, as a "diversified" strategy, sector timing is winning the battle against a very difficult stock market.

Conclusion

Over the years, sector fund timing may go down as the "best strategy ever created" because of its ability to target funds into "only" those industry sectors which are performing well.

The low drawdowns, low volatility and diversification inherent in sector timing, not to mention strong profitability, cause this strategy to stand out from all the others.

In volatile market conditions, such as we are experiencing now, sector timing can create profits when other traders are lucky just to be holding onto their capital. Drawdowns, if they occur at all, become almost a non-event. A one or two percent drawdown in a sector that is only one-sixteenth of your portfolio, will not cause anyone to lose sleep.

While sector timing may not make huge gains during cyclical bear markets, being mostly in cash, the strategy will protect your investment capital. And it will then outperform during bull markets, always keeping you invested in those industries that are in their own bull markets. And remember, cyclical bear markets are not an every-day occurrence.

Sector timing also requires a minimum account size. Remember, there "could" be as many as 16 open positions at any one time, and closed (bearish) positions should be in cash (money market funds) with those funds remaining untouched. A good guess is that a sector timing portfolio should be at least $20,000 - $25,000 to start if using a Rydex or ProFunds account.