Investors who are just beginning to fill out their investments may gravitate toward name brand stocks that they are familiar with, but a sector exchange traded fund may be a better option to diversify a portfolio.
“Investing in sectors can provide diversification benefits that, compared with single-stock ownership, may reduce portfolio volatility,” Fidelity Investments strategists, led by Scott O’Reilly, said in a research note.
Specifically, the Fidelity strategists argued that sector investments significantly diminish downside risk, which may could improve investor outcomes, especially among those less risk tolerant.
In a portfolio of stocks compared to a portfolio of sectors for the period between 1995 through 2015, Fidelity found that an investor’s risk profile significantly changed when moving from stock holdings to sector and to a diversified portfolio. Specifically, single stock exposure showed 35% idiosyncratic risk and 10% market risk when analyzing annualized volatility based on weekly returns, whereas a sector portfolio showed 7% idiosyncratic risk and 13% market risk.[related_stories]
Broad sector plays would allow investors to limit potential downsides relative to investing in individual stocks while helping investors gain exposure to any upside potential, essentially limiting the swings that may cause some to prematurely dump a holding. Fidelity research found that there is 55% less downside risk in sectors, compared to single stocks, when comparing 12 month excess returns for portfolios of skilled investors in the period 1995 through 2015.