Investing 101 – The Importance of Sector Diversification

penny stocks, young investorsThere are very few absolutes — if any — in the world of investing, but diversification is one truism that actually works no matter what the market throws at you. If you want to gain an edge in your portfolio while minimizing risk, diversification is a must.

Think about where you would be without diversification. Imagine investing your entire net worth in one stock. What happens if that stock collapses? You conceivably could lose everything. The gunslingers out there will tell you the flip side also is true. Own one stock that goes up fantastically, and great riches will follow.

True, but there is a reason the gunslinger sleeps with his finger on the trigger. He is nervous — actually, downright fidgety. The same would be true for the investor owning one stock. I highly doubt a single-stock investor would have one night go by without high anxiety, especially in a market like we have seen during the past few years.

I’ll gladly exchange the upside for a restful night of sleep. Protecting capital is a huge benefit of diversification. As for that upside, I still can generate market outperformance by spreading out my risk over a larger number of stocks.

Typically, a portfolio will achieve sufficient diversification with 20 to 40 stocks, but it is important to go beyond just those numbers. Investors also need to think about sector diversification. If an entire portfolio of stocks is allocated to one sector, the benefits of diversification — mainly risk reduction — disappear.

For example, owning a portfolio of 30 stocks in the homebuilding sector would not have been a good idea prior to the housing market collapse. Sure, while home prices skyrocketed, homebuilding stocks did very well, but putting all of your eggs in one basket would have ultimately proven disastrous.

The same is true in 2011 with the airline sector. Airline stocks are some of the worst performers this year. It would have been very risky to own a portfolio of airline-focused stocks only. It would not matter if you had owned one airline stock or 100 — diversification in that manner would not have saved your portfolio when the sector declined.

Instead, investors would be wise to be stock diversified, but also sector diversified. Own a bank stock, a utility stock, a transportation stock, a technology stock, so on and so forth. That way your portfolio will obtain the full benefits of diversification.

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