Why Security and Sector
Diversification Are Important
A White Paper by Manning & Napier
www.manning-napier.com
Unless otherwise noted, all figures are based in USD.
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Why Security and Sector Diversification Are Important | A White Paper by Manning & Napier
Security diversification refers to the allocation of a portfolio
across different securities, so that no single security
makes up too large a percentage of the portfolio. Sector
diversification takes this idea one step further, making
sure that the portfolio is distributed among multiple
economic sectors. History has shown that limited security
and/or sector diversification can result in significant
portfolio volatility and can negatively affect a portfolio’s
risk management profile. Events such as the bear market
following the Nifty Fifty craze in the early 1970s, the
internet bubble of the early 2000s following the technology
boom of the late 1990s, and the financial crisis from
2007-2009 after years of outsized real estate growth and
mortgage lending are all examples of supposed “can’t
miss” investments whose eventual declines erased a great
deal of shareholder wealth, especially for investors who
overweighted these sectors/securities.
Security diversification is important to all investors
regardless of their investment objectives. How many
securities must an investor hold to be adequately
diversified? In order to gain a better understanding of this
complex question, the graphic below displays the general
relationship between risk and the number of securities in a
portfolio.
Non-Systematic/
Diversifiable Risk
Systematic/
Non-Diversifiable Risk
Number of Securities
As illustrated above, adding securities to a portfolio can
reduce risk considerably, although there is a point where
adding additional securities generally provides limited
benefits. Exposure to an abundance of securities can
potentially offset the benefits of the active fund manager’s
investment decisions and may lead to index-like returns
less the value-added fees charged by actively managed
funds. In general, when a portfolio holds at least 20-30
distinct securities, non-systematic risk can be minimized.
Non-systematic risk is sometimes referred to as random or
diversifiable risk since it is related to unique factors specific
to a particular company and/or the industry in which the
company operates. The decline of Mattel stock1 during
2014 (i.e., from a price of $47.58 on 12/31/2013 down to
$30.95 on 12/31/2014) as a result of consumers’ transition
from Barbie dolls to more technoligically advanced toys,
and the collapse of several of the Financial Services
sector’s bellwethers in 2008 (e.g., Lehman Brothers,
Bear Stearns, AIG) provide just a few examples of the
potential non-systematic risk that can be reduced through
diversification. Since incorporating exposure to multiple
securities will help reduce random security specific risk,
exposure to any one particular security should generally
be limited to approximately 5% of a portfolio’s value.
However, it is worth noting that you cannot eliminate all
risk even by extensive security diversification. The risk
that remains even after extensive security diversification is
called systematic risk, or market/non-diversifiable risk.
Likewise, sector diversification is an important issue to
investors. In many cases, a portfolio that has security
diversification concerns will also have sector diversification
concerns. In other words, a portfolio concentrated in
only a few holdings is also likely to be concentrated in
a few economic sectors. However, investors should be
aware that even though their portfolio may be adequately
diversified at the security level, it is still possible to have
concerns regarding limited sector diversification. In
allocating such a significant portion of a portfolio to a
single economic sector, there is a risk that any near-term
weakness in the sector could result in significant volatility
in the value of the portfolio.
The chart on the following page highlights how
overweights to different economic sectors can
meaningfully affect a portfolio’s performance. Specifically,
the chart depicts that the annual returns of the ten sectors
of the S&P 5002 for each of the last five years varied
meaningfully.
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Why Security and Sector Diversification Are Important | A White Paper by Manning & Napier
For example, in 2014, the S&P 500’s2 best performing
sector (i.e., Utilities at 28.98%) significantly outperformed
the worst performing sector (i.e., Energy at -7.78%).
Furthermore, even though all ten sectors were positive in
2010, 2012, and 2013, there was meaningful variability
in returns across the sectors (i.e., returns range from just
over 1% to over 43%). Clearly, incorporating diversification
across multiple economic sectors improves a portfolio’s
overall risk management profile and can reduce the
likelihood of dramatic fluctuations in value.
Sector Returns for the S&P 5002
Sector
2010
2011
2012
2013
2014
Consumer Discretionary
27.66%
6.13%
23.92%
43.08%
9.68%
Consumer Staples
14.11%
13.99%
10.76%
26.14%
15.98%
Energy
20.46%
4.72%
4.61%
25.07%
-7.78%
Financials
12.13%
-17.06%
28.82%
35.63%
15.20%
2.90%
12.73%
17.89%
41.46%
25.34%
Industrials
26.73%
-0.59%
15.35%
40.68%
9.83%
Information Technology
10.19%
2.41%
14.82%
28.43%
20.12%
Materials
22.20%
-9.75%
14.97%
25.60%
6.91%
Telecommunication Services
18.97%
6.27%
18.31%
11.47%
2.99%
5.46%
19.91%
1.29%
13.21%
28.98%
15.06%
2.11%
16.00%
32.39%
13.67%
Health Care
Utilities
S&P 500 Total Return
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Finally, there have been instances where seemingly welldiversified market indexes have become concentrated
in a single economic sector. For example, despite being
cited as a diversified U.S. stock market index, Information
Technology stocks comprised over 30% of the S&P 5002
at the end of 1999 and Financials grew to represent over
22% of the S&P 5002 by the end of 2006. Not surprisingly,
these overweighted sectors contributed significantly to the
S&P 500’s2 subsequent declines (i.e., the stock market
experienced two of the worst bear markets in history in
2000 - 2002 and 2007 - 2009, led by these two sectors
respectively).
Analysis by Manning & Napier. Source: Bloomberg, Morningstar. ©2015 Morningstar. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be
copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information, except
where such damages or losses cannot be limited or excluded by law in your jurisdiction. Past financial performance is no guarantee of future results. All data are subject to revision.
The data presented is for informational purposes only. It is not to be considered a specific stock recommendation.
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The S&P 500 Total Return Index is an unmanaged, capitalization-weighted measure of 500 widely held common stocks listed on the New York Stock Exchange, American Stock Exchange, and the Over-the-Counter
market. The Index returns assume daily reinvestment of dividends and do not reflect any fees or expenses. Index returns provided by Morningstar. S&P Dow Jones Indices LLC, a subsidiary of the McGraw Hill Financial,
Inc., is the publisher of various index based data products and services and has licensed certain of its products and services for use by Manning & Napier. All such content Copyright © 2014 by S&P Dow Jones Indices
LLC and/or its affiliates. All rights reserved. Neither S&P Dow Jones Indices LLC, Dow Jones Trademark Holdings LLC, their affiliates nor their third party licensors make any representation or warranty, express or implied,
as to the ability of any index to accurately represent the asset class or market sector that it purports to represent and none of these parties shall have any liability for any errors, omissions, or interruptions of any index or
the data included therein.
2
Approved CAG-PUB008 (5/15)
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