Diversification simply means spreading your risk. The idea is that different sectors and industries are exposed to different risks and therefore, they will take turns outperforming or underperforming in different economic or market environments.
For example, you wouldn’t want 50% of your dividend portfolio in bank stocks because they would get hit hard in a financial crisis or recession.
Although during a recession, likely all sectors and industries will be impacted, some will recover faster than others. That’s where it’s advantageous to hold a diversified portfolio versus one that’s concentrated.
Today, I’ll introduce a few ways to think about stock portfolio diversification. Here’s a dividend stock portfolio building example.
Diversification by sector and industry
The Global Industry Classification Standard (“GICS”) categorizes stocks across 11 sectors, 24 industry groups, 69 industries, and 158 sub-industries.
The 11 sectors are Communication Services, Consumer Staples, Consumer Discretionary, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Real Estate, and Utilities.
The rule of thumb is to not own more than 25% of one’s stock portfolio in a sector. You don’t necessarily need to invest across all 11 sectors, though. For instance, many Energy, Materials, and Industrials stocks have more unpredictable earnings due to the ebbs and flows of the economic cycle.
Therefore, it might serve investors (especially new investors) better to start investing in the other 8 sectors first. However, coming out of a recession — in an economic expansion, Industrials stocks would do very well.
Notably, Biotech stocks, in the Health Care sector, are highly unpredictable as well. Small-cap biotech stocks could be multi-baggers or make investors lose their shirts!
Some sectors have more industries to choose from. You don’t need to invest in all industries. Play with the interactive tool at the GICS website to see the various industries.Read More