“Diversification is protection against ignorance. It makes little sense if you know what you are doing.” We don’t often disagree with Warren Buffet, but sector investing lets you gain exposure to all the important areas of the economy.
Many investors try to deal with the uncertainty of investing by diversifying. But there’s more to sound portfolio diversification than simply buying a variety of stocks. After all, an investment grab-bag may reveal heavy concentration in a few economic sectors.
You’re far better off to diversify using sector investing. This approach lets you gain exposure to all the important areas of the economy. Most stocks fall into one of these five sectors, or broad economic categories: Finance, Utilities, Manufacturing, Consumer products and services, and Resources.
■ Finance: This sector consists of the banks and trust companies, investment and mutual fund firms, insurance businesses and financial management companies. A drawback of companies in this group is that they use a lot of borrowed money. This multiplies the impact of their mistakes.
■ Utilities: This group includes all companies—pipelines, electric utilities, telephone companies—that supply an essential service at regulated rates, and enjoy some government-enforced protection from competition. Investors used to think of utilities as a shelter from change, but that’s become increasingly less so. Nowadays, for instance, the trend toward deregulation has let Canadian telephone companies increasingly compete within each other’s territories. Still, utilities tend to be a highly dependable source of income.
■ Manufacturing: Products of these firms are used or consumed over periods longer than one year, or are used by other firms. Here we include chemicals, construction, steel, home appliances, autos and so on.
■ Consumer products and services: These companies serve individuals or businesses, and their output generally gets consumed by them in a short period of time. For instance, foods and beverages, communications (magazines and online content) and so on all fall into this category.
■ Resources: This sector consists of metals and other sorts of mining stocks, as well as oil and gas and forest products firms.
Multi-sector firms are involved in more than one sector. For instance, Canada’s railways ship goods associated with many sectors. These include resources (oil & gas), manufactured goods (cars) and food (wheat).
The five-to-20 rule
If you want exposure to all main areas of the economy, you need a minimum of five stocks—one for each economic sector. Each stock in your portfolio, on the other hand, should generally account for five per cent or more of the portfolio’s total value. Anything less than that and it will have little impact on your portfolio’s performance. Worse, you may fail to stay in touch with developments that influence so small a part of the total. For all but the biggest portfolios, then, the optimum number of stocks is usually somewhere between five and 20 or so.
If you want to give each sector equal representation, you’d put 20 per cent of your assets in each. But that strikes us as a shade too rigid. Better to let your commitment in each sector vary between 15 to 25 per cent, depending on your own personal inclination, knowledge or investment goals. As we’ve often pointed out, finance and utility stocks generally involve below-average risk. Manufacturing and resource stocks involve above-average risk. The consumer sector is somewhere in between.
Paying attention to economic sectors forces a certain discipline on an investor. It stops you from hopping from one fad to the next.
Traders and speculators may prefer to concentrate in a particular economic sector because short-term opportunities do tend to bunch up. Today, for instance, some speculators may choose to ‘diversify’ by owning a variety of stocks that stand to benefit from rapid advances in technology. As well as holding pure technology stocks, they may also invest in consumer stocks.
If you choose to concentrate on a limited number of sectors, however, you should at least be aware of what you are doing, and consider what will happen if your forecast proves wrong. Maybe that’s a more prudent way of paying heed to what Warren Buffet had to say about diversification.
This is an edited version of an article that was originally published for subscribers in the October 4, 2019, issue of The Investment Reporter. You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter.
The Investment Reporter, MPL Communications Inc.
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