How to use sector diversification to manage risk

Wednesday, Sep 14 2016 by
33
How to use sector diversification to manage risk

I’ve interviewed some well known investors and fund managers this year, and they’ve all divulged interesting investment approaches. Each has had strong personal views on investment styles, ranging from small-cap growth to large cap value. But one area where the waters are muddy is on the issue of diversification.

Portfolio diversification is a subject that divides opinion, and it’s one that most investors approach by thinking in terms of numbers. It ends up being a balancing act between offsetting the risk of single failures against the costs and effort of managing dozens of positions. On this point, even the pros have differing views. Small-cap fund manager Giles Hargreave is content with over 200 hundred holdings, while the likes of Schroders’ Nick Kirrage is more than happy with 40, and even less.

But there’s more to diversification than looking for safety in numbers. Being aware of how resilient a company is to the broader economy is important in managing exposure and smoothing returns over time.

Understanding sector sensitivity

All stock market data services - like Thomson Reuters, which is used by Stockopedia - categorise companies based on the sector they fall into. At the top level, there are three super-sectors: Cyclicals, Defensives and Sensitives, and then 10 sectors that are divided between them.

CyclicalsDefensivesSensitives
Basic MaterialsHealthcareIndustrials
Consumer CyclicalsConsumer DefensivesEnergy
FinancialsUtilitiesTelecoms


Technology

Broadly speaking, Cyclical sectors are those most sensitive to macro trends and the general health of the economy and consumer sentiment. Among them are mining stocks, high street retailers and banks. Defensives, on the other hand, are seen to be less reliant on the economy because they sell goods that we buy in good times and bad. They include pharma companies and tobacco and utility groups. In between are the Sensitives, which move with the economy but to a lesser extent than Cyclicals.

One distinction between Cyclicals and Defensives can be seen in something called Beta. Beta is a measure of the sensitivity of a company’s share price to the movement of the market (usually over the past five years). If a stock’s price tends to rise more than the market on up-days and fall more than the market on down days, it will have a Beta greater than 1. But if it isn’t as sensitive to market movements, rising less and falling…

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Disclaimer:  

As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.


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2 Comments on this Article show/hide all

Warranstar 15th Sep '16 1 of 2

Ben, thanks for this highly informative article.
Would it be too much of an oversimplification to say that the above "Sensitives" are of medium cyclicity?

And how about a follow up piece which:
1) Helps us to know which stage of the cycle we are in.
2) Identifies which sectors may be viewed as Buy / Hold / Sell for each of the different stages of the economic cycle.

Paul.

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herbie47 15th Sep '16 2 of 2

Ben, why are Charles Taylor (LON:CTR) in the Cyclicals?

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About Ben Hobson

Ben Hobson

Strategies Editor at Stockopedia. My goal is to help private investors learn and invest with confidence through the articles, ebooks and other resources we publish on site. I also occasionally bunk off to interview famous investors at expensive restaurants. I studied History at Aberystwyth University, trained as a journalist and covered business news and corporate finance before settling in as one of the first staff members at Stockopedia.  Away from Stockopedia I'm a mountain bike junkie. more »

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