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Sector diversification is a term used in investing to describe the purchase of shares in a carefully selected number of companies in the major industry groups outlined, as opposed to using the entire resource to buy shares of just one. The main reason to practice sector diversification is to mitigate any risks that may occur if any one of the sectors experiences a downturn. The ranking of major industries includes areas such as healthcare, consumer products, finance and manufacturing, among others.
Active sector diversification gives the investor an advantage as a result of exercising prudence. This means that this investor realizes that it is not good investment practice to acquire shares of just one sector as an investment. Even if the investor is lucky and the industry goes through a period of tremendous or steady growth, something could happen in the future to cause that particular industry to crash or crash. The crash could be the unfolding of a general downturn in the economy or it could be the result of other trends that could affect that particular sector. Whatever the situation, the fact remains that sectoral diversification serves as a kind of safety net for the investor who does not want to be surprised by any negative trend that could affect his investment.
For example, if an investor who has $100,000 US dollars (USD) decides to use all of the money to buy shares in an airline, any factor that causes a decline in travel patterns will heavily affect the investor. Assuming there are a number of terrorist threats that cause passengers to avoid flying en masse, the value of airline stocks will plummet in response. If the airline in which the investor bought shares decides to close as a result of a prolonged or sustained loss, the investor will lose money.
On the other hand, the investor may have invested $35,000 USD in the airline, $35,000 USD in purchasing shares in a pharmaceutical company, and the remaining $30,000 in purchasing shares in a steel mining plant. In this case, the investor’s portfolio will only suffer to the extent that it is affected by the $35,000 invested in the airline. As such, the investor still has stocks in the other two industries to help absorb the impact of the loss. Sector diversification only helps investors spread the risk involved in investing by diversifying their portfolio.