A major challenge in creating a diversified stock portfolio is identifying the specific securities to include. Of course you want strong individual stocks, mutual funds, or exchange traded funds (ETFs) whose return will boost the value of your account. Equally important, you want a combination of holdings that as a group will help you profit from the strength of the overall market — or parts of it — at the same time as it helps protect you from the risks of market downturns or problems with specific holdings.
With so many equity investments to choose from, you need a way to narrow the field. One approach is to begin by focusing on different sectors, or groups of companies in similar businesses.
Because each sector varies in certain distinctive ways from the others, selecting securities from a variety of sectors can contribute to the diversification you seek. For example, a simplified hypothetical portfolio that included shares in a brokerage firm, a pharmaceutical company, a consumer appliance manufacturer, a software provider, a telecommunications firm, and an oil company is more diversified than one holding shares in four banks and two car manufacturers.
Of course it’s also crucial to evaluate the individual securities within each sector you’re considering, as you make investment decisions.
Uses of sector investing
Greater diversification is just one of the potential benefits of investing in different sectors. You can use this approach to accomplish other goals as well.
If a brokerage firm or independent research suggests that certain industries within a sector seem poised to provide substantial growth over an extended period — perhaps because they manufacture medical devices demanded by an aging population or are exploring alternative sources of fuel — you may decide to invest in that area.
If a particular sector is out of favor with investors, you may want to identify underpriced securities with long-term promise to add value to your holdings. Or, if you want to use a small percentage of your principal to speculate, you might home in on a specific sector that you think will provide significant returns in the short term. The risk with speculation, of course, is buying at the top of the market in a particular sector and increasing your risk of substantial losses.
Finally, you might invest in one or more sectors to provide a hedge for a portfolio that may be overloaded in a specific area.
