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How Important is Sector Diversification for the Average Investor?

Chances are that if you have been investing for any period of time, you have heard about the extreme importance of diversification. 

While I do agree for the most part, I also think that sector diversification is one of the most overrated rules of investing for the average investor.

For starters, diversification is essentially spreading out your investments into many different groups that theoretically shouldn’t have a huge impact, or any impact at all, on your different investment groups. 

For instance, you might invest in financials because if your tech investments are hit with major, industry wide concerns (such as the China trade tariffs) then the financials should help keep the rest of your portfolio from being hit with these same issues. 

Diversification could mean anything – it could mean investing in bonds vs. stocks, or domestic investments vs. foreign investments, or anything at all that won’t be correlated with other investments.

That being said, typically when people are talking about diversification, they’re referring to spreading their investments out among the 11 different sectors in the stock market.  Those 11 sectors include:

  1. Financials
  2. Utilities
  3. Consumer Discretionary
  4. Consumer Staples
  5. Energy
  6. Healthcare
  7. Industrials
  8. Technology
  9. Telecom
  10. Materials
  11. Real Estate

If I was writing this 3 months ago then I would be talking about one major reason to not necessarily worry about trying to diversify into all 11 sectors is because the commission fees could stack up on you rather quickly, but fortunately for us, so many brokerages are now offering $0 commissions that we do not have to worry about that concern anymore!

That being said, do not mistake the $0 commission for being my only reason not to sorry about diversifying in all of the 11 sectors. 

I’d like to really preface the rest of this post by saying that this is highly opinionated and there really is no right or wrong answer that fits everyone – it’s 100% up to the investor and it can vary by investor and their investing style, so I am only going to talk about how I invest and why I invest in this way. 

So, do I invest in all 11 sectors?

Heck.  No.

My personal investing philosophy is to be as risky as I can be without being reckless.  I am very firmly of the mindset that the younger you are, the riskier that you should be with your investments because you will have more time to recover if things do not work out for whatever reason. 

I know I already said it, but please note that I am saying that I am not being reckless.  I am still looking for the margin of safety and still looking to identify stocks that pay a strong dividend.

My concept of risk is not worrying about things like diversification.  I am seeking to find the best deals 100% of the time and I am not limiting myself to a certain sector of the market because that’s what I need to make my portfolio “diversified”. 

If I am just starting my investing journey and I have $5000 and I want to put $5000 into 5 different stocks, and I think that the best 5 deals are all in 2 or 3 different sectors, then who cares!

Do not limit yourself to investing in every single sector because you could be passing up opportunities that you think are a better value only because you want to “balance” your portfolio.

I am a huge Warren Buffett fanboy and even he thinks that diversification isn’t always the most optimal thing to do, and he’s one of the best, most conservative value-investors that this world has ever seen…

“Wide diversification is only required when investor do not understand what they are doing.”

–Warren Buffett

If I was age 60 and getting very close to retirement, would I have 100% of my stocks all in tech?  No way!  That would be the definition of reckless.  You need to find a strategy that fits your lifestyle, but I prefer to not prioritize diversification for a few reasons.

2 – Find the best deal

I will not sacrifice the value that I see in a certain company to invest in another just because they’re in a different sector.  Would this change for me at some point? 

Sure. 

But I am young and more worried about finding the next big thing than I am worried about protecting my downside.  I don’t care about my strikeouts as long as I’m swinging for the fences and hitting some homeruns too!

2 – I do not know enough about 11 different sectors

Truthfully, I barely know enough about 11 different companies to know if they’re worthy of investing in (slight exaggeration but still!).  If I know tech, then tech is where I am going to start with my investing because I immediately have a better base knowledge than I do for other sectors. 

I personally work in the energy sector, so I feel like I have an advantage over most when evaluating energy companies, so that’s an area that I will focus on.

“Invest in what you know”

–Peter Lynch

3 – You have to risk it to get the biscuit

This one goes hand in hand with #1, but it is slightly different.  I inherently know that some sectors are riskier than others and I do not shy away from those, I’m actually attracted to them! 

I will go out of my way to look for the risk and then try to identify opportunities in those risky sectors of the market to hit that homerun.  I know that not everyone is like this, but for the average investor, I think that trying to hit homeruns early in your life is a great plan. 

If you invested $5000 for 30 years at an 8% return, your total at Year 30 would be $50,313.  If you were to get 12% returns the fist 5 years and then go to 8% for the last 25 years, you would have $60,347 after 30 years – a 20% increase over the 8% interest returns!! 

I know that $10,000 might not seem like a lot, but these are relatively low investing amounts – the key thing to focus on is that because you were risky and outperformed the market by 4% for 5 years, your total returns are now 20% higher than the steady growth rate option. 

Summary – don’t hesitate to be risky.

Diversification by nature is meant to reduce risk.  This has a time and a place, but the time and place are not for a new, young investor that has an average amount of funds invested.  It is for the people that are getting close to retirement and really need that money in the immediate future for and are depending on it for their survival.

For you, my new investor – get after it!  Don’t worry about being diversified.  Find the best deal, stick to what you know and don’t hesitate to be risky!