Asset Allocation: Is It Bad to Invest Heavily in One Sector?

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Recently, one of our Twitter followers expressed concern that his portfolio might be too tech-heavy. After all, he's a computer programmer, so it makes sense that he feels comfortable with half of his portfolio made up of tech stocks. Is this lack of diversification something to be concerned about, or is it a smart idea to invest heavily in companies whose business you understand?

In this Industry Focus: Financials clip, host Jason Moser and Fool.com contributor Matt Frankel, CFP, give their two cents.

A full transcript follows the video.

This video was recorded on Jan. 7, 2019.

Jason Moser: OK, Matt, let's go back to Twitter for one more question this week. This was one we got over the break from @ChrisM_Jones. Chris asks, "Would love to have your take on portfolio allocation. I received my annual portfolio review for my broker and went through it. I had never really thought a lot about sector allocation but wanted to get your take on the importance or lack thereof on sector allocation. My portfolio is 52% "tech." I'm a computer programmer scientist, so I try to invest in what I know best. I'm also overweight in consumer cyclical and basic materials and underweight all other sectors based on comparing to the S&P 500. Thanks in advance for your insight."

Matt, this is a big, wide ranging topic, portfolio diversification and allocation. I thought it'd be a neat opportunity for us to talk a little bit about it and give Chris some ideas. What do you think there of what Chris tells us about his situation?

Matt Frankel: I don't think he's doing anything wrong, really. I just mentioned Peter Lynch's book, One Up on Wall Street. The whole underlying theme of it is to invest in what you know. Right before we recorded, I tallied up some of the numbers from my own portfolio. This actually surprised me -- my portfolio is 56% split between real estate investment trusts, REITs, insurance companies, and banks. The three things I know the best make up well over half of my portfolio. Tech is right up there, too. I'm overweight tech. I'm very underweight things like healthcare, which I know nothing about. Underweight in a lot of industrials, which I don't understand that well. I wouldn't know enough to make good investments in those areas. If anything, I would probably buy an index fund that invested in healthcare stocks because I don't really know.

Having said that, there's a limit to the "invest in what you know" thing. There's a reason I don't have 100% of my portfolio in REITs, although I feel that's probably the best one of the best long-term opportunities right now. You still want to find the best of the best in the other sectors. If you don't know a sector that well, it's a really good strategy to either, A, buy an index fund like I just mentioned, or, B, find the best of the best players in that industry with big competitive advantages that aren't going anywhere. To give you an example, I'm not a tech wizard or anything like that, but I know enough that Apple's a great company, which is why Apple is very overweight my portfolio right now.

That's my advice. If you do feel you need a little bit of diversification into sectors you're not too familiar with, if you need to get into banking, for example, either the XLF, that index fund I mentioned a few weeks ago, or one of the big banks like JPMorgan Chase, you really can't go wrong with one of those. Again, invest in what you know. I wouldn't dive into like any small-cap or mid-cap stocks in an area that you don't know very well. But as far as the best players in the sector or index funds, that's the way to go, in my opinion, if you're not too familiar with the sector and need a little more diversification in your portfolio.

Moser: Yeah. I was reading this question, and the first thing that came to mind was Warren Buffett's quote regarding diversification. He says, "Diversification is protection against ignorance. It makes little sense if you know what you're doing." I think there's something to this. The first thing that I think is, don't diversify just for the sake of saying that you're diversified. If you're investing in something that you have no idea about, that's not diversification, that's just bad investing. If you don't know anything about materials, or cyclicals, or energy, healthcare, whatever it may be, don't just assume that you have to have that exposure because it makes for good diversification. To your point, having a fund probably makes more sense in those areas where you're not so familiar with the actual space.

I also want to go back to one thing. In 2018, remember that the S&P Communications Services sector was launched. Essentially, the S&P made this new sector. Everybody at this point probably feels like they're over-exposed to tech. That's because most of the things in our lives all revolve around tech in one way or another. But the S&P put together this S&P Communications Services sector. This sector ultimately included companies from three different industry groups -- telecommunications, technology, and also consumer discretionary. The basic idea was that we are in such a tech-driven world today that a lot of these companies are viewed a little bit differently today than they were perhaps 10 or 20 years ago. The main point here is, if you feel like you're overweight tech, well, that makes a little sense because we're in such a tech-driven world today. I don't think that's ultimately a bad thing.

To take a little bit of a bigger picture view, less about markets or sectors, and focusing more on small-cap, large-cap, mid-cap, things like that, I went to our Premium Pass offering here at The Fool to look through some of the portfolio tools that they have. They have some recommended allocations there for folks who are either in that grow-your-wealth phase or defend-your-wealth phase. Just to give some numbers there, in the grow-your-wealth phase, the recommendations in Premium Pass -- these are, of course, workable. Nothing is set in stone. They're saying, if you're looking to grow your wealth, have 25% of your portfolio in large-caps, 15% in mid-caps, 15% in small-caps, 30% in international, which I found interesting, 10% in alternatives, which could be real estate or REITs like you were talking about earlier, Matt, and 5% in bonds. But generally speaking, the idea with that grow-your-wealth portfolio is, you can take on a little bit more risk at that point. That's why you have such heavy exposure to stocks.

If you go to the defend-your-wealth portfolio, they have large-cap at 25%, mid-cap at 10%, small-cap at 10%, international at 10%, alternative at 5% and bonds at 40%. Those are things to keep in mind. Every investor is a little bit different in their goals and their stage of life. If you're older and you need to focus on protecting your wealth, you need to allocate a little bit differently and make sure that you're taking some of that risk off the table.

We could probably go on for hours just talking about diversification and allocation. Chris, we hope that helps out with your questions there.