Increase the likelihood that your investment portfolio will remain healthy, even in a flat economic environment, by making diversification a core investment principle. Horizontal diversification is important to ensure your portfolio includes a variety of investment types, while vertical diversification creates depth within each type. When it comes to purchasing stocks, look beyond the total number and add vertical depth by picking stocks by sector. A good diversification and risk-reduction strategy is to pick stocks from a variety of sectors and set a limit to ensure your portfolio is not overly heavy in any individual sector.
1. Identify individual stock sectors -- groups of stocks that have similar industry affiliations -- according to their four-digit Standard Industrial Classification, or SIC Code. Each uses the first two digits to identify a major industry, the third digit to identify the industry group and the fourth to identify a specific subsection of the industry. Review SIC codes on sites such as Barchart.com for information and general education.
2. Generate a list of sectors that interest you and then evaluate the general direction of the market for each sector you are considering. Investment research sites such as NASDAQ provide industry comparison information that uses a weighted alpha – a positive or negative number that indicates direction over a specific period such as a year – to help you evaluate overall industry performance. Rank the sectors you are considering according to their weighted alpha.
3. Create a list of the top-producing stocks within each sector. Just as industry comparisons use a weighted alpha, so do individual stocks within each sector. Look at the weighted alpha of individual stocks as well as general information on stock upgrades, downgrades, performance, earnings and “Hold,” “Buy” or “Sell” recommendations on sites such as NASDAQ, Barchart and InvestorGuide.
4. Pick top-performing stocks from among the sectors that fit in with your investment goals and ability to handle risk.
- Another way to identify stock sectors is by market sector classification. Although its perspective is somewhat broader, market sector classification uses a “drill down” approach similar to identifying sectors according to their SIC code. For example, at the time of publication the “Media” classification comprises eight industries, of which “Publishing-Books” is one. Drilling down further reveals companies offering stocks in the “Publishing-Books Industry,” including McGraw-Hill, Scholastic Corporation, Pearson and John Wiley.
- Do not be too quick to eliminate a sector even if its general market direction is poor. Remember that every stock, no matter how well it is currently performing, carries a degree of risk and that your goal is diversification. Even in a flat or downward direction, poorly performing sectors may have a “shining star.”
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