If you have been an investor for any time, you may have heard the phrase “don’t put all your eggs in one basket.” Such advice mostly reflects the importance of diversification within an investor’s portfolio. With the future as uncertain as it is, betting all your money on a concentrated number of stocks can be a risk not many can afford.
Several large-scale market crashes reflect the need for diversifying the stocks one invests in. These include the Internet Bubble of the 2000s, the Housing Market collapse of 2008 and the Covid Crash in recent times.
Hence, diversification is a concept investors must familiarize themselves with to protect themselves against such uncertainties. In this article, we will be exploring one particular type of stock diversification strategy: Sector Diversification
What exactly do we mean by Diversification?
Diversification broadly refers to an investment strategy whereby the portfolio consists of assets from different categories of stocks. This can include, but is not limited to, sectors/industries and geography. This diversification, in theory, reduces the extent of losses since these are spread across multiple stocks. Hence, if one industry suffers a decline, others can balance for the loss.
For example, investments in airline or tourism industries before the pandemic may have created huge unexpected losses for investors. If such investors diversified by purchasing stocks of the medical industry and telecommunication, they could balance out these losses. This is because these two industries experienced growth in the era of COVID.
Most financial professionals agree that diversification allows for the long-term realization of financial goals. This is because it maximizes returns in the long run while minimizing risks.
The latter goal is achieved by investing in various instruments or sectors which react differently to the same event. It helps avoid volatile and unsystematic risks which may harm concentrated financial investments.
What is Sector Diversification?
Of course, considering the broad type of stocks available on the market, there are different diversification strategies. In this article, we will be analyzing Sector Diversification. So, what exactly do we mean by this term? Sector Diversification is a strategy whereby investor portfolios consist of stocks from various industries.
This means that investments are spread across various sectors that may have little to nothing in common. These sectors essentially group companies that have similar goals or purposes. This includes healthcare, travel, energy, real estate, or any other sector of the economy. For instance, there are different advantages or disadvantages to holding various kinds of stocks at any particular time.
Some industries may be more stable, while others may have greater growth potential. According to the proponents of this strategy, it allows for greater risk management for portfolios. This is because concentrated economic investments can lead to volatile results due to unsystematic shortcomings and downfalls.
In general, there are eleven market sectors which consist of companies that engage in similar projects. This includes:
The Materials Sectors:
Focusing upon companies engaged in processing or extraction of raw materials. This includes mining companies or construction supply firms.
The Industrials Sector:
This includes engineering companies, aircraft, and car manufacturers, industrial machinery companies, etc. In general, companies focused on the production of large-scale capital goods come under this umbrella term.
The Health Care Sector:
Companies that are involved in the manufacturing of pharmaceuticals or companies that provide healthcare services etc. are involved in this sector.
The Energy Sector:
This usually includes stocks from companies engaged in the extraction or refining of fossil fuels. Do note, however, that companies producing renewable source energy usually come under the industrial or utility sector.
The Utilities Sector:
Companies that are involved in the production or distribution of water, electricity, or natural gas usually have stocks that come under this sector. Since most of these companies are highly regulated monopolies, investments are low-risk and low-volatility.
The Communication Service Sector:
This includes telecommunication companies and the media and entertainment sectors as well.
The IT sector:
The IT sector can be divided into companies that specialize in hardware and those which specialize in software development. It also involves companies that provide internet services to digital businesses and corporations.
The Financial Sector:
Simply, this sector involves brokerage, insurance funds, pension funds, and the sort. Companies dealing with that will be constituted under the financial sector.
The Consumer Discretionary Sector:
This includes businesses that are dependent upon the demand consumers have for them. This could range from automobile companies to restaurants and hotels. They could be volatile but can also reap great value as well.
The Consumer Staple Sector:
Companies that deal with day-to-day necessities of life are grouped under this sector. This could include producers of bread or alcohol.
The Real Estate Sector:
While mortgage managers fit under the Financial Sector, the management of real estate development and investment trusts is grouped under this sector.
As we can see, stock market sectors create clear distinctions, which make it very accessible for investors to navigate through. It also allows them to analyze and compare different trends that are emerging through different sectors.
Advantages of Sector Diversification
The advantages of diversification in itself are many and varied. In this section of the article, we will integrate both the general advantages to having a diversified portfolio and the specific advantages of Sector Diversification. Let us get right to it:
1) Limited Risks
The concept behind diversification is to minimize risks, and so having this as the first advantage is no big surprise. When you concentrate your portfolio with similar types of investments, the chances of them falling apart can lead to great losses. This is because assets can be volatile and prone to unsystematic or unplanned risks.
Diversifying your assets help to dilute these risks and maximize returns in the long run. Private wealth management firms such as RVW Wealth prioritize convenience and personalization for their customers. For this reason, they will look towards diversification as a way to ensure returns for their customers and mitigate risks.
Diversifying across sectors here can be a very intriguing tool when it comes to risk management. While offering the cushion of diluted risks, it can also help customers adapt to different sectoral trends. An example of this was given above relating the aircraft and healthcare investments during the era of the COVID-19 pandemic. Such diversification indeed follows a Sector Diversified strategy.
2) Opportunity Cost of Not Investing and Barrier against Market Cycles
In the past, various transaction fees cut into the profitable potential of diversification. Now, various wealth management groups eliminate these brokerage costs and transaction fees, making diversification a much more profitable outlet. This, in turn, means that the opportunity cost of not diversifying is very high in the modern digital age.
With the ever-increasing nature of technological development, social media trends, and changes, you never know which asset will grow or plummet. In such a scenario, it is not only safer but economically more valuable to diversify into various unrelated sectors. This may seem quite cumbersome for those who are currently profiting from concentrated investments.
However, international financial crashes and bursting bubbles indicate that this is not very sustainable. One can lose all their valuable gains overnight in today’s market. Hence, it is financially astute for an investor to diversify their investments; this creates a barrier against market cycle volatility whilst providing assured returns.
3) Peace of Mind and Less Required Monitoring of Portfolio
Diversified financial instruments, such as exchange-traded funds, will allow you to allocate your assets along with different sectors and industries. This allows peace of mind since there is little worry of any major loss. Risks are mitigated when an investment portfolio is spread across different sectors, and rewards are maximized in the long run. That is the logic of the proponents of Sector Diversification.
Additionally, you need little time to actually maintain or monitor your own portfolio. This is because you aren’t exploring market trends on a daily basis along with a narrow sector or asset class. Your investments are spread across multiple sectors, and so your movements are much more regularized, and risks are mitigated.
Of course, the risk management portion of Stock Diversification is its main selling point and the reason why so many finance professionals recommend this strategy.
Importance of Diversification in Modern-Day Investing
Now we come to the heart of the article: what exactly is the importance of sector diversification in the modern-day? You may have got your answer already, but if you didn’t, then this section of the article is tailor-made for you.
The modern world is one where every economic or value-producing institution is in a constant state of flux. Industries are restructuring and constantly changing, while social media trends lead to short-lived bubbles or fads that can rock your portfolio in unpredictable ways.
The global pandemic in the last two years has shown how different institutions can react to the same event in different ways. At the same time, financial crashes such as the Lehman Brothers crash in 2008 show how seemingly unrelated institutions can react in the same way to the same event. Such complex conclusions can be overwhelming and confusing for investors who wish to safeguard their portfolios from uncertainties.
In these circumstances, sector diversification comes into play as a possible solution to these dilemmas. By wagering on different industries with little correlation and a high potential for growth or stability, it is easier to safeguard investments.
You can protect your portfolios from the unnerving flow of the market and unsystematic risks by diluting those risks and making your long-term growth model more sustainable. For this reason, Sector Diversification is an essential strategy in the current age, and the state of the financial world can necessitate you contemplating this strategy.
In this article, we analyzed the various nuances surrounding Sector Diversification. After analyzing the concept and fundamental reasoning behind the development of such investment strategies, it is quite easy to figure out the importance of their existence.
With a world so prone to change and uncertainties, we need protection and guarantees against our risks. The use of Sector Diversification strategies ensures that such protections and barriers are put in place. Besides this, such strategies also allow investor the ability to create progressive portfolios that expose an investor on different kinds of futuristic developments.
August 25, 2021