Thoughts on managing sector risk

22nd Dec '13 by mpat89

10 comments 7257 reads

Hi all,

Just wondering if anyone has read any academic research or whether any conclusions have been reached with regards to the allocation of a portfolio between each sector. Stockopedia gives us a market average allocation in the portfolio function, but is this likely to be an optimal weighting? e.g. most "opportunities" are in industrials with sectors like telecoms providing very few opportunities. This makes some sectors extremely easy to buy shares in while others are quite difficult.

Regards,

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About the Author

Mpat89

Premium Member

Chartered Accountant

10 comments

jjis

31st Dec '13

Hi,
Your question is related to the age old question of diversification. Hopefully you might find the following useful.
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=276048

http://www.efficientfrontier.com/ef/900/15st.htm

Happy New Year

mpat89

28th Apr '15

So is it better to allocate the portfolio according to the sector risk of the market, or to try and split the sector risk evenly, i.e. 10% per sector?

Damian Cannon

28th Apr '15

My view is that it's better to allocate evenly between sectors if you're trying to remove sector risk/bias. I have a couple of reasons for thinking this:

1) The market doesn't allocate more capital to some sectors rather than others because it's somehow efficient or omniscient. All it's doing is reflecting which sectors are 'hot' and which are not. In fact you might argue that weighting in line with the market is a very bad idea because 'hot' sectors inevitably deflate from their bubble.

2) If you're weighting one sector more than another then you're implicitly (or explicitly) predicting that these sectors are going to perform better in future. Given the track-record of most futurists I believe that very few people are able to forecast anything beyond the very near-term and those that do seem to get it right could just be lucky.

Do you feel lucky?

Damian

UK Value Investor

29th Apr '15

I like equal weighting, or more specifically an equal cap on any one sector. So in my case I don't want more than about 10% of my portfolio in any one sector (using the official FTSE Sectors), so I limit myself to no more than 3 stocks in a particular sector out of 30 holdings in total.

Graham Neary

29th Apr '15

If you are passive: invest in the index and don't worry.

If you are active: invest most heavily in the sectors which you understand the best.

In my humble opinion.

Edward Croft

29th Apr '15

Hi Graham, Perhaps but that strategy didn't work out so well for tens of thousands of oil and gas investors recently ! I find the 'invest in what you know' philosophy leads too many into poor investments.

Graham Neary

29th Apr '15

Good point Ed, where I disagree is that I bet tens of thousands of those investors don't have a proper understanding of the sector, it's just the one which they happen to find the most exciting!

If it's true that someone has expertise only in a risky/difficult sector such as energy, they should be investing passively with the funds that they can't afford to lose IMHO.

pka

29th Apr '15

"If you are active: invest most heavily in the sectors which you understand the best."

A problem with following that advice is that usually the sector which a person understands the best is the one he works in. If he invests heavily in that sector and it experiences an economic downturn, he might lose both his job and a large part of his investments.

Graham Neary

30th Apr '15

That's true too.

The problem is that risk comes in many different forms. Since managing risk while investing actively is very difficult, I recommend to all of my friends to invest passively.

If you are an active equity investor, the risk I highlight the most is the risk of not understanding the businesses you are buying, because understanding what you are buying is foundational to any investment, and is the most basic form of risk control.

But then there are other risks too, besides what can go wrong with individual companies - macroeconomic risks, personal correlation risks, and many others. And If someone can't bear those risks, then I would suggest that active investment is not for them.

GrindertraderUK

30th Apr '15

I believe a dangerously strong bias can be formed if one is an expert in any sector to then heavily weight their own investment on it. My profile title is 'I work in the Oil and gas Industry, I do not invest in the Oil and gas Industry'

I like to think I have strong knowledge of not only my particular profession within the O & G industry, but of the whole industry that includes exploration, production, geo-political and natural events effecting the costs of Oil.

It is because I understand the volatility & risks that I would never weight heavily in this particular sector (if at all). I have said this for years, and I have proven (whether through luck, guesswork or on the other end of the scale being a complete genius (not), that although no one can predict the future in this industry that investors were just too confident in O&G that one day the price would inevitable fall.

I know there is many Oil investing Guru's out there but you have to be well and truly above and beyond the average investor to contemplate investing in it. Especially the exploration side!

Maybe I am biased towards O&G but in the opposite direction. I have feared investing in this sector and this year my fears have proven to have saved me from ruining my portfolio balance.

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Thoughts on managing sector risk

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Mpat89

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