Sector Diversification: Spreading Across Sizes and Countries Too

Open your list of holdings and write a sector next to each line. It takes a few minutes. It also answers a question the number of lines can’t, which is whether your stocks are separate bets or the same bet placed several times over, perhaps months apart and for reasons that felt unrelated when each order went in.

The labels most investors use come from the Global Industry Classification Standard, which sorts listed companies into 11 sectors and then into narrower industry groups, industries and sub-industries. The 11 sectors are communication services, consumer discretionary, consumer staples, energy, financials, health care, industrials, information technology, materials, real estate and utilities. Brokerage research pages and fund fact sheets usually show a company’s sector, and a company’s own annual report describes what it sells if the label seems off.

Why one sector is one bet

Companies in the same sector tend to move together. They share customers, costs and sensitivities. Energy producers rise and fall with the price of oil and gas. Banks respond to interest rates and loan losses. Utilities and real estate companies often react to rates too. The explainer on how rising interest rates affect dividend stocks works through that link. When the thing driving the sector turns, it turns for all of them.

So a portfolio of many stocks from one sector carries less company-specific risk than a single stock, as the previous lesson showed, while leaving you fully exposed to whatever hits that sector.

Eight names look diversified on a statement. With six in one sector, it behaves more like two or three positions. One of them is very large. New money sent to the thin areas can fix that gradually, and the lesson on rebalancing a portfolio shows how, including why it can spare you a tax bill in a taxable account where selling your biggest winners would realize the gain.

Size is a second dimension

Companies are also grouped by size: large, mid and small caps. Size here means market capitalization, the share price times the shares outstanding. The dollar cutoffs vary depending on which index or fund is doing the sorting. Small companies tend to swing more in price than large ones, and the two groups don’t always lead or lag at the same time, so a portfolio made entirely of the biggest companies, or entirely of small ones, is concentrated along this line even when its sectors look balanced.

Check yours. A mix of sizes spreads the bet.

Country is a third

Where a company is based shapes its currency, its regulators and the economy it leans on most, although many large US companies sell a lot abroad and so give you some foreign exposure without your owning a single foreign share. Owning companies based in other countries adds a different kind: their shares trade in other markets and are priced in other currencies, so their returns in dollars also move with exchange rates, up or down.

How much of each to hold is your call. The point for now is to know where you stand on all three.

Funds can be concentrated too

A fund holding hundreds of stocks sounds diversified by definition. It may not be. Some broad indexes weight companies by market cap, so a handful of very large companies can make up a big share of the fund, and if those companies sit in the same sector, the fund leans that way as well.

Sector funds are the plain case. A fund that holds only health care companies can own a hundred of them and still be one sector bet, which is fine when you chose it on purpose and a problem when you count it as the spread-out part of your portfolio.

Now you can see the spread. The next question is how to fill the gaps. The lesson on funds or individual stocks compares the two ways of doing it. Cost is part of that. More on long-term portfolio topics sits in the investing hub.