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Sector diversification involves buying shares in multiple industries to mitigate risks of downturns in any one industry. It is prudent to diversify to avoid being caught off guard by negative trends. For example, investing in multiple industries can help absorb the impact of a loss in one industry.
Sector diversification is a term used in investing to describe buying shares in a carefully selected number of companies in the major industry groups outlined, rather than using your entire resource to buy shares in just one. The main reason to practice sector diversification is to mitigate any risks that may occur if any one of the industries experiences a downturn. The ranking of major industries includes areas such as healthcare, consumer products, finance and manufacturing, among others.
Active sector diversification offers the investor an advantage as a result of exercising prudence. That is, this investor realizes that it is not good investment practice to buy stocks in just one sector as an investment. Even if the investor is lucky and the industry undergoes a period of tremendous or steady growth, something could happen in the future to cause that particular industry to crash or crash. The crash could be the result of a general downturn in the economy or the result of other trends that could affect that particular industry. Whatever the situation, the fact remains that industry diversification serves as a kind of safety net for the investor who doesn’t want to be caught off guard by any negative trends that might affect their investment.
For example, if an investor with $100,000 (dollars) decides to use all that money to buy shares in an airline, any factor that causes a downturn in travel patterns will hit the investor hard. Assuming there are a number of terrorist threats that drive passengers away from flying en masse, airline stock values will plummet in response. If the particular airline in which the investor has purchased shares decides to close as a result of an extended or sustained loss, the investor will lose money.
On the other hand, the investor might have invested $35,000 in the airline, $35,000 in buying stock in a pharmaceutical company, and the remaining $30,000 in buying stock in a steel mining plant. In this case, the investor’s portfolio will only suffer a loss insofar as it is affected by the $35,000 invested in the airline. As such, the investor still owns shares in the other two sectors to help absorb the impact of the loss. Sector diversification just helps investors spread the risk involved in investing by diversifying their portfolio.
Asset Smart.
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