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What Is Sector Diversification?

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  • Written By: Esther Ejim
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 03 September 2016
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Sector diversification is a term that is used in investment to describe the purchasing of stock in a carefully selected number of companies in the delineated major industry groups as opposed to using the entire resource to purchase stock in only one. The main reason for practicing sector diversification is to mitigate any risks that might occur if any one of the industries experiences a downturn. Classification of major industries include areas like healthcare, consumer products, finance and industry, among others.

Active sector diversification offers an investor an advantage as the result of the exercise of prudence. That is to say that such an investor realizes it is not a good investment practice to purchase stock in just one industry as an investment. Even if the investor is lucky and the industry experiences a period of tremendous or steady growth, something could happen in the future to cause a slump or crash in that particular industry. The crash could be the offshoot of a general downturn in the economy or it could be the result of other trends that may affect that industry in particular. Whatever the situation, the fact remains that sector diversification serves as a sort of safety net for the investor who does not wish to be caught unaware by any negative trend that may affect his or her investment.

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For example, if an investor who has $100,000 US Dollars (USD) decides to use all of the money to purchase stock in an airline company, any factor that causes a depreciation in travel patterns will affect the investor heavily. Assuming there are a series of terror threats that cause passengers to stay away from flying in droves, the value of the stock in the airlines will plummet in response. If the particular airline in which the investor purchased stock decides to close as a result of a prolonged or sustained loss, the investor will lose money.

On the other hand, the investor might have invested $35,000 USD in the airline, $35,000 USD in the purchase of stock in a pharmaceutical company, and the remaining $30,000 USD in the purchase of stock in a steel mining plant. In this case, the investor’s portfolio will only suffer a loss to the degree that it is affected by the $35,000 USD invested in the airline company. As such, the investor still has the stock in the other two industries to help absorb the impact of the loss. Sector diversification merely helps investors spread the risk involved in investment by diversifying their portfolio.

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ddljohn
Post 3

Diversification may reduce risk, but I doubt that it eliminates risk altogether.

I mean, when the economy is not doing well, don't all sectors get affected to some degree? I don't think it's unlikely that more than several sectors will experience loses when there is an economic crisis in the country.

So may be in addition to diversification, it's a good idea not to invest too much money in any one sector. So if things turn sour, there isn't much to lose. Am I right?

burcinc
Post 2

@stoneMason-- An investor should try to invest in a variety of unrelated sectors, unrelated being the key. The reason is that if someone invests in many sectors that are related to one another, he might not be reducing risks very much. So the idea is to invest in very different sectors that will not affect one another if things were to go wrong for one sector.

The only disadvantage of diversification is that too much diversification can be bad as well. There is actually something called over-diversification. It's usually defined as investing in thirty or more different places at once.

The issue with too much diversification is that it makes it difficult for the investor to keep up with developments in each sector. So the investor may not make wise decisions or may not take action when necessary.

stoneMason
Post 1

In order to benefit from the advantages of diversification then, should an investor invest in as many sectors as possible? Does sector diversification have any disadvantages?

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