As the various stock markets in the world increasingly move in tandem, diversification and optimal returns are more likely to be achieved if evolving changes in sectors are taken seriously in portfolio management. To achieve true diversification in your portfolio, sector allocation may be a better bet than relying on international investments. Let's take a look at sector diversification and how it can reduce risk and boost portfolio returns.

SEE: The Importance Of Diversification

Why Go for Sectors?
The right sector can often outperform broad market indexes. A study by UBS Warburg investigated the correlation between stock exchanges in various different countries and regions as well as the sectorial correlations. The study indicated that over time, international stock market movements correlate progressively more strongly with one another. A correlation coefficient of only 0.1 at the end of the 1970s rose to almost 0.7 by 2002. This enormous rise has major implications for optimal portfolio construction and risk management.

In the previous decade, investment experts did indeed predict that traditional asset allocation between regions would gradually be replaced by an increasing emphasis on industry sectors. In practice, however, investments remain heavily oriented around geographic regions.

The worldwide globalization and liberalization of goods and capital markets, the crisis with the euro and the bursting of the hi-tech bubble all served to highlight the need to shift the relative emphasis away from regions and countries to industry sectors, such as biotechnology or natural resources. This does not necessarily mean risky investment in volatile sector funds, but rather using the low correlation with other asset classes in order to reduce risk.

The point is that diversification, achieved through a portfolio that is very evenly divided between sectors, may show worse performance than a portfolio that shifts the focus sensibly and prudently according to changes in the investment, economic and even social landscape.

Conventional Diversification
A well-balanced portfolio will be invested adequately in the various sectors comprising of the national and, possibly, international economy. Banks, technology, mining, industrials and utilities are generally present in mixed equity portfolios and those need to be the case.

However, active sector management is not so common and this is unfortunate. Going sensibly overweight on some sectors and underweight on others can make a big difference to your risk and return situation.

The wide selection of sector funds available enables you to take advantage of changing and evolving market conditions. Of course, in order to do so, you need to follow the dynamics of the various sectors on an ongoing basis, but this is not always difficult in this age of information.

A Simple Principle
Focusing on sectors makes a lot of intuitive sense. There are always parts of the local or international economy that fall into one of three categories listed below:

  • Those that are promising
  • Those that are doing well now
  • Those that are doing too well and booming

For instance, when resources are flat, canny investors will see this slump as an opportunity and perhaps an ideal time to move into that sector. When the market starts to move, it will still be a great investment; when it gets too hot, it becomes risky and it may be time to shift sectors again. That is the basic way in which sector rotation works.

Keeping Risk down and Returns Up
This sector allocation concept is also related to theme investing. There can be no doubt that if you find a theme that is on the up-and-up, you can make money. However, caution is needed in order to avoid real market timing, which is notoriously unreliable. Likewise, trendy and minor themes can also be risky.

The big plus with more established sectors and themes is that it is not really that difficult to detect when a sector looks like it is set to rise. There is also plenty of information available about the various sectors. If the prices are historically low and there are indications that demand is likely to rise, then going just a bit overweight in that sector is a fair risk. It is not a matter of "timing," but rather of shifting a bit more money into broad categories that look like sensible investments at the time.

The main thing to watch is so-called weak signals in the market for sectors that are likely to do well over time. As always, when profits and prices are already high and people are charging in, it is probably too late to get in and, even more likely, it may be time to get out.

SEE: Sector Rotation: The Essentials

The Bottom Line
It is simply in the nature of economics and business that all sectors do not do equally well at one time. On the one hand, this means that diversification is essential to avoid the major losses that can occur by having most of your money in one sector or one part of the economy. However, without trying your luck at classic and controversial market timing, it is possible, by being well informed through the media, to figure out which investment sectors and themes look likely to rise above the crowd in the short- to medium-term. Without getting carried away, a sensible move into such sectors can improve your investment returns.

Nonetheless, as soon as you do this, you need to make sure that you remain vigilant so that you can reverse the weightings if the signals from the market turnaround. As with any form of active management, it needs to be accompanied with ongoing monitoring, control and discipline.

Related Articles
  1. Investing Basics

    Diversification Beyond Stocks

    If you think holding several stocks means you're diversified, think again - there's much more to be done to reduce portfolio risk.
  2. Investing Basics

    5 Things To Know About Asset Allocation

    Overwhelmed by investment options? Learn how to create an asset allocation strategy that works for you.
  3. Retirement

    7 Common Investor Mistakes

    Find out how to avoid - or fix - these frequent investing errors.
  4. Active Trading

    Why Investments That "Feel" Safe May Not Be

    Investors tend to be adventurous in situations where they feel protected, but risk compensation theory suggests this may backfire.
  5. Fundamental Analysis

    Is Your Portfolio Overweight?

    As time passes, in order to remain profitable, investors need to put certain parts of their portfolio on a diet.
  6. Mutual Funds & ETFs

    3 Fixed Income ETFs in the Mining Sector

    Learn about the top three metals and mining exchange-traded funds (ETFs), and explore analyses of their characteristics and how investors can benefit from these ETFs.
  7. Mutual Funds & ETFs

    Mutual Funds Millennials Should Avoid

    Find out what kinds of mutual funds are unsuitable for millennial investors, especially when included in millennial retirement accounts.
  8. Bonds & Fixed Income

    High Yield Bond Investing 101

    Taking on high-yield bond investments requires a thorough investigation. Here are looking the fundamentals.
  9. Mutual Funds & ETFs

    Top 3 Commodities Mutual Funds

    Get information about some of the most popular and best-performing mutual funds that are focused on commodity-related investments.
  10. Retirement

    How Robo-Advisors Can Help You and Your Portfolio

    Robo-advisors can add a layer of affordable help and insight to most people's portfolio management efforts, especially as the market continues to mature.
  1. Why have mutual funds become so popular?

    Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>
  2. Do mutual funds pay dividends?

    Depending on the specific assets in its portfolio, a mutual fund may generate income for shareholders in the form of capital ... Read Full Answer >>
  3. What licenses does a hedge fund manager need to have?

    A hedge fund manager does not necessarily need any specific license to operate a fund, but depending on the type of investments ... Read Full Answer >>
  4. Can mutual funds invest in hedge funds?

    Mutual funds are legally allowed to invest in hedge funds. However, hedge funds and mutual funds have striking differences ... Read Full Answer >>
  5. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
  6. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  2. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  3. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  4. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  5. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  6. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!