How to Diversify Your Portfolio by Sector

As you might already know, diversification is one of the best strategies that you can implement to reduce your equity portfolio risk. Although there are many types of diversification techniques, equity investors often prefer sector-wise diversification over methods. This is because sector-based risk management is often very simple to execute and is more often than not effective at reducing the negative impact of unfavourable market movements. 

Sector Diversification Strategies and Tips That You Can Implement 

Wondering how to implement sector-wise diversification? Here are a few tips and strategies that you can follow. 

Look for Sectors with Little to No Correlation

To achieve proper diversification, it is important to not invest in sectors that are closely related to each other. For instance, the retail sector and consumer goods sector have a high positive correlation, which means that they mostly move in tandem. Investing in both of these sectors will not help reduce your portfolio risk. 

Therefore, when diversifying sector-wise, it is a good idea to pick stocks from sectors that have little to zero correlation. For instance, you can consider investing in the pharmaceutical, agriculture, energy and finance sectors, all of which are not related to one another. This way, you can reduce investment risk significantly. 

Focus on Major Sectors  

When diversifying, many investors tend to gloss over major sectors, which are more often than not the primary drivers of an economy. Such a move not only reduces the wealth creation potential of your portfolio but also makes it more vulnerable to unfavourable market conditions. 

Therefore, as an investor who is intent on portfolio diversification by sectors, you need to ensure that you invest in the major sectors. This includes banking and finance, pharmaceuticals, information technology, agriculture, fast-moving consumer goods (FMCG) and energy. 

Use the 5 Percent Rule for Diversification within a Sector 

It is natural for a particular sector to have multiple sub-sectors. Take the case of the energy sector. It consists of various sub-sectors such as oil and gas, wind energy, hydroelectric energy and solar energy. 

Sector-based risk management also includes sub-sectors within a sector. So, if you’re planning on diversifying by investing in sub-sectors of a primary sector, consider using the 5 percent rule. According to the rule, your investment in a particular sub-sector shouldn’t exceed 5 percent of your total investment capital. This rule, when strictly implemented, can restrict overexposure and protect you from market downturns. 

Follow Sector-Wise Representations of Major Indices 

Adopting the sector-wise representations of major indices is one of the simplest sector diversification strategies that you can implement. Take the case of the NIFTY 50 index and its top 5 sectors. It allocates about 38.44% towards financial services, 12.4% toward information technology, 12.15% toward oil and gas, 9.73% toward FMCG and 5.52% toward automobile sectors. 

You can use the sector-wise representation of a broad market index such as the NIFTY 50 or maybe even SENSEX as a guideline to create an investment portfolio. In addition to helping you diversify by sectors, this will also allow you to replicate the performance of the index to a certain extent. 

Focus on Cyclical and Defensive Sectors Equally 

Cyclical sectors often have strong wealth creation abilities, whereas defensive sectors are more resilient to market volatility and downturns. When diversifying your portfolio, it is important to focus on both of these kinds of sectors more or less equally. This way, you can ensure that you don’t sacrifice wealth creation ability in exchange for protection from market downturns or vice versa. 

Conclusion

As an investor, you need to keep in mind that portfolio diversification by sector on its own may not guarantee complete protection from volatility and unfavourable market movements. It is important to also focus on diversifying your portfolio across asset classes. This will provide your portfolio with more comprehensive downside protection.