How To Make Your Own Optimal Sector Allocation?

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Includes: C, CEL, KMI, LMT, MMM, MSFT, PTNR, XOM
by: Khen Elazar

Summary

As I invest new capital on a monthly basis, an important question is how to allocate it.

When people usually talk about allocation they are talking about allocating the portfolio between stocks, corporate bonds, government bonds, CDs, cash etc.

In this article, I will discuss the allocation of stocks between the sectors.

Introduction

My followers know my strategy as a dividend growth investor. I invest the same amount of money every month consistently. I pick individual stocks on a monthly basis that hopefully will pay me a growing stream of dividends. Every month I analyze several stocks, and choose one or two to buy.

Executing your investing plan is very important. You must have a pattern while choosing stocks. If you just choose stocks that seem attractive, you might expose yourself to serious risks. One of the risks is being over allocated to one sector.

Over the past several years, as I have been growing my portfolio, I found my own optimal allocation. Of course it might change in the future as I learn more about different companies, different sectors, and about my own strategy. At the moment I am happy with the my current optimal allocation.

Allocation Sector
20.0% Consumer Staples
12.5% Health Care
12.5% Industrials
12.5% Financials
10.0% Consumer Discretionary
10.0% Energy and Materials
8.0% Information Technology
7.0% REITs
5.0% Telecommunications
2.5% Utilities

The risk of ignoring sector allocation

Many investors are using cheap ETFs and mutual funds like the ones offered by Vanguard. They enjoy the low fees, and the fact that they don't need to monitor their investments. They let Vanguard do the sector allocation for them. This is not the case for the investor who chooses individual stocks that fit his strategy.

The risk of choosing too many stocks from the same sector, and having a large part of your portfolio invested in similar companies is massive. Over the past 20 years, we have seen how some sectors practically imploded, as stocks in the sector underperformed the entire stock market.

In 2010, a new reform in the telecommunication in Israel shocked the whole industry. The share price of major cellular operators in Israel plunged by up to 75%. Companies that seemed like blue chips like Cellcom (NYSE:CEL) and Partner (NASDAQ:PTNR) stopped paying dividends, and investors were panicked.

The same happened not so long ago in the United States, in the energy and basic materials sector. As the prices of commodities dropped, most companies in these two sectors tumbled. MLPs like Kinder Morgan (NYSE:KMI) cut their dividends, even Exxon Mobil (NYSE:XOM) plunged drastically.

Of course the best examples are the dot com bubble, and financial crisis of 2008. The first one harmed IT companies, while the second one smashed financial institutions. It took companies like Microsoft (NASDAQ:MSFT) more than 15 years to reach its all time high again. Companies like Citi (NYSE:C) will probably need decades to return to its 2007 highs after the stock price plunged by over 90%.

I can add more and more examples like, but I believe that the point is now clear. Sectors imploded in the past, and they will probably implode in the future. Having adequate diversification is crucial to deal with that risk.

Becoming familiar with the sectors

First, you must become familiar with the sectors: all eleven of them. It is also important to know which sub sectors and industries are in each sector. Lockheed Martin (NYSE:LMT) and 3M (NYSE:MMM) are both in the industrial sector. Yet, they are different companies, from different industries.

You should strive to own companies from many industries. For example, the financial sector of your portfolio should include both banks and insurance companies. Personally I made a slight adjustment to the sector allocation, and I combined energy with basic materials. Try this link to Wikipedia, and it will give you basic knowledge of the sectors.

Allocating the capital between the sectors

The easiest way is to choose an index and follow its allocation. For example, allocate your capital the same way the S&P 500 or the Dow Jones are allocated. However, I believe that if you decide to choose your stocks, it will make sense to choose your own allocation for your portfolio, and it will hopefully be more suitable for you.

You should allocate capital to every sector. Start by allocating 10% to each sector. This will be your basic allocation, and now you should start adjusting it according to several parameters that includes volatility and global diversification.

The easiest way to understand which sectors are more volatile than others is to take a look at the ETFs. SPDR offers a specific website that will help you analyzing the sectors. You can see how large each sector is in the S&P, and see its past performance. The only sector that SPDR doesn't offer an ETF for is the telecommunication.

Look at the beta of each ETF in Yahoo Finance. The beta will show you how volatile each ETF, and therefore each sector is. You should use it to balance the portfolio volatility with your appetite for risk. If you build a volatile portfolio without the ability to see deal with the risk of volatility, you might sell your stocks during the next bear market.

Now that you are aware to the volatility of each sector, you can balance them. It makes sense to use less volatile sectors as anchors in your portfolio. Consumer staples and utilities are less cyclical, while energy, basic materials and consumer discretionary tend to be more cyclical. Remember that the younger you are the higher you ability to deal with volatility. However, this is very personal, and every investor should ask himself, how will he deal with a 50% decline in his portfolio value.

Now you have your allocation, and you will probably adjust it several times in the future. It is time to fill it with stocks from different industries. When you choose companies, try to look for companies that are diversified globally. It will help you in reducing the risk, and lowering the volatility of your portfolio. You can look at this article to see who I analyze and choose stocks.

Explaining my allocation

Consumer staples is the core of my portfolio. These companies are less volatile, and they sell products that people use on a daily basis. Utilities is also stable, but suffers from slower growth, and therefore I only allocated 2.5%.

After suffering from too high allocation to cyclical sectors like energy and basic materials, I decided to allocate to them 10% together. The three main sectors that I hold together with consumer staples are healthcare, financials and industrials. Moreover, I believe that in the future IT will get higher allocation. At the moment it is hard to find suitable candidates that fit me in this sector.

Conclusions

Picking your stocks requires more work than just buying index funds. Ignoring sector allocation might have devastating effect on your portfolio, and your long term returns. Reducing risks is a crucial part of investing.

Take a close look at the sectors, understand them, and combine this understanding with your appetite for risk. Make sure you analyze your current and optimal allocation every quarter or two.

Disclosure: I am/we are long C, LMT, MMM, XOM.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.