Why Diversification of Sectors Matters (Risk Management)!

So depending on what you’re investing allocation looks like, these past couple weeks may have been detrimental to you’re portfolio if you have only been in speculative tech growth stocks. Of course if you have been in some of these speculative tech stocks since the beginning of Covid, you are still up huge. But for those that have started recently or added heavily to these positions after their runs up, it’s a different story because it’s not “house” money.

But when it comes to investing it’s all about the current environment and looking forward that actually matters. Plus I don’t love the whole “house” money, because actually that money is now yours and I think should be treated like any other deposit into your brokerage account. With a possible rotation into value and bond yields creeping up, does it make sense to continue to allocate to higher growth stocks at these valuations?

Also if we had a crystal ball, we would have all yoloed into tesla calls back in march 2020 and been billionaires at this point. But there once again is the difference between speculation vs. investing. 

As I have said in the past, each person has a different objective with investing and risk management is king. I think being able to limit your downside and protecting your capital is extremely important.

For me, I see risk management as one of the most important tools you have to keep your emotions in check as an investor and to align your investments appropriately. Don’t know your risk tolerance? Well you can take a quick quiz like the following from vanguard to see where you fall when it comes to your risk appetite.

Lower Risk Takers

For those that that don’t want to be bothered to go the extra mile to research companies, think about investing strategy, and don’t want to over complicate. That is why index funds are great. They give you the diversification without much effort from your side.

Below is the sector weighting of the S&P 500 (an index of 500 companies). When you invest in an index you get the diversification across multiple sectors and companies. This spreads the risk of having one company going bankrupt taking you down or one sector getting hit hard and causing you large paper losses.

For beginners or passive investors this is a great place to start with index ETFs  (SPY, QQQ, DIA)!

Medium Risk Takers (Where I Land)

For those of you that don’t want to blindly invest into companies just because they are part of an index, nowadays you can essentially create you’re own index with you’re own weightings.

For instance, below is my weightings across industries.

This allows me to tailor my allocation to certain industries that I believe will outperform and allocate a higher % to that sector than those that may not perform as well. This requires some active management and thinking how to rebalance as the investing environment changes and may present an opportunity to a certain sector (for instance this post I made on the steel industry being ripe for outperformance at the beginning of the year).

The risk here is obviously less companies being invested in, less passive, you have to pick reasonably/undervalued stocks within each sector, and you are making assumptions about which sectors will do well as you rebalance.

High Risk Takers

This section is for those of you that think I’m a complete idiot and can pick the perfect company guaranteed to take you to the moon! Nothing wrong with that 🙂 If you have a higher risk tolerance and want to speculate, diversifying may not make as much sense. If you concentrate your investments into a couple companies and they do well compared to the overall market, you will come out are way ahead. But the opposite is true as well.

If you are okay with this risk then it may make less sense to invest in index funds or a variety of companies/industries.

Conclusion

At the end of the day, diversification is a way to manage risk. For those of you that want to be more active or aggressive with your growth, it makes less sense to diversify. For those that want to spread the risk, you can invest in different companies/sectors.

With no fees attached/fractional shares, you can be your own portfolio manager without worrying about being destroyed by commission fees.

If you want to keep up to date how I personally invest/rebalance you can check out the premium patreon.