Diversify by sector?

Stock portfolios are tricky concepts. We all know about the need to balance our assets according to various, and very well repeated, practices. Diversification as a risk management concept is one which is often treated as gospel among even those who don’t fully understand it. There’s no doubt that your portfolio needs diversification - mine sure as hell has it. The problem is, most people (and unfortunately, financial planners) don’t understand what proper diversification really is. This can lead to strategies built on totally false ideas. Sector diversification is one I \continually see people using as a way of ‘avoiding a dot com-like meltdown’ in their portfolio. In truth, it doesn’t avoid anything.

James Montier discusses the perils of using sector rotation as a strategy. In short, even if you guess the life cycles perfectly, you still only make around 2% p.a more, assuming some fairy gives you the definitive guide on exactly what each sector is in what position. If anyone meets such a fairy, I would love for her (or his?) number to be forwarded to me so I can profit by selling this report to gullible individuals, not by a meager 2% rise in portfolio worth. Even fund managers, those who are supposed to be in the know, couldn’t use the core values of a sector strategy for their clients, and all end up ‘destroying value for clients’. And they make up around 35% of accounts managed in the US market. The world financial markets constantly reminds me of what a cess pool of bad information and mediocre individuals it really is.

So, what can be done to smarten up your portfolio? Use both overseas and domestic stocks, use bonds so you’re never fully vested, diversify in index funds, and keep everything balanced on paper. This should keep your risk down and your returns normal. “But I want abnormally high gains!” I hear you say. Don’t we all? The good news is, they are obtainable to the right
investor. The bad news is, it requires more complexities, more courage, more restraint, and persistence. And you can’t get it with simplistic approaches, or by reading the latest book written in honor of Warren Buffett.