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Sector Investing: Building a More Diversified Portfolio

As times change, so do the leading stock market sectors. As a result, some investors may be tempted to "chase returns" by investing in the market's "hot" sectors.

But a better approach for investors who want the potential to outperform the broader market over the long term may be to blend sector funds to balance risk and return potential.

A Multi-Sector Approach

When establishing your asset allocation, the foundation of your equity portfolio may be broad stock investments, such as funds that invest in large-cap stocks in any market sector. But if you're pursuing capital appreciation, and can tolerate higher levels of risk, you might choose to devote a portion of your portfolio — 10%, for example — to a narrower segment of the market through sector funds. By investing in a sector or a handful of sectors, you may be able to give your portfolio a performance edge over one that is strictly diversified across the entire equity universe. Of course, you'll also take on more risk with the addition of sector funds.

But by holding a diversified "basket" of sectors, you can potentially create a more attractive risk/return profile for your portfolio. As you construct your sector basket, keep the following factors in mind:

Each sector is driven by a unique set of economic fundamentals. Financial services companies, for example, may be heavily influenced by interest rates and broad economic conditions. Health care companies, on the other hand, can be greatly affected by new product development and demographic trends, such as the aging of the population. These differences are illustrated by correlation statistics — measures of the degree to which one investment performs similarly to another. By holding a mix of sectors with low correlations, you may diversify your portfolio more effectively and help reduce risk.

Sectors perform differently in any given time period — some lag the market, while others lead it. But trying to guess which sector will take the lead next is difficult even for professionals, and can be costly. If you guess wrong and miss just a few of a particular sector's best days, you risk sacrificing potential gains.

Managing Sector Risk

Keep in mind that sector funds may experience greater short-term price volatility than more diversified equity funds and are best suited for the aggressive portion of a portfolio. Investing in specialty market sectors carry additional risks such as economic, political or regulatory developments that may affect many or all issuers in that sector.

In addition to holding a diversified basket of sector funds, these steps may help you cope with the risks of sector investing:

  • Have a long-term holding period-3 to 5 years or more.
  • Limit your exposure to sector funds — perhaps 10% to 15% of your portfolio, depending on your goals and risk tolerance.
  • Take advantage of your financial advisor's guidance in selecting sector funds that fit your needs.

Mutual funds are offered with a prospectus. Investors should consider the investment objectives, risks and charges and expenses of the investment company carefully before investing. The prospectus contains this and other information about the investment company. You can obtain a prospectus from your financial representative. Read the prospectus carefully before investing.

© 2010 Standard & Poor's Financial Communications. All rights reserved.