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Sector Concentration Risk – Are you too Overweight in Certain Sectors?

Sector Concentration Risk – Are you too Overweight in Certain Sectors?

Peter Silfvander

Sector Concentration Risk – Are you too Overweight in Certain Sectors?

In general, people tend to invest in what they know. Investing in companies within a certain sector or market that you are familiar with gives you a better understanding of how news and announcements may affect your holdings. Investing in your ‘circle of competence’, be it the bank you bank with or the company’s products you use, has been advised by many famed investors including Peter Lynch and Warren Buffet.

Sector Concentration Risk

Investing in discretionary goods that you use and know daily seems reasonable, right? Moreover, this product category, consumer discretionary, was the best performing sector on the ASX for FY2021. So why not just buy stocks in all the discretionary goods companies one uses daily?

First of all, past performance is not an indicator of future performance.
More importantly, while it may be a good idea to invest in what you know, holding a high weighting of your portfolio in one or several sectors brings sector concentration risk. Sector concentration risk is systematic risk and arises from the high correlation between stocks in a certain sector, meaning if one discretionary goods stock goes down, another is likely to as well, and vice versa. The same goes for other sectors, like information technology, although some stocks are more highly correlated to their sectors than others.

COVID-19 and Sector Concentration Risk

The effect of this was seen during the market downturn during the COVID-19 downturn of March 2020, where the ASX200 consumer discretionary index fell 45.1% from the 20th of February to the 23rd of March. However, the ASX200 utilities index over the same period only posted a 27.0% decrease. Being overweight in consumer discretionary companies during this period would have greatly diminished the portfolio value during this period and especially hurt investors who panic-sold in the downturn.

Sector Performance within the Economic Cycle and Stock Market Cycle

While you might excuse the pandemic-induced downturn as a rare event, sectors routinely perform differently through economic and stock market cycles.

Economic cycle: The fluctuation of the economy between growth (expansion) and contraction (recession) with the peak being the highest point in the growth phase, and the trough being the lowest point in the contraction phase.

Stock market cycle: The fluctuation of the stock market between bullish (growth) and bearish (contraction) movements with tops and bottoms in between.

This means periods in economic cycles and stock market cycles have historically favoured certain sectors as seen below.

The economic cycle and stock market cycle are correlated, but there exists a lag on the economic cycle. The economic cycle’s lag is caused by pre-existing contracts and service obligations, as well as the periodic reporting of the underlying economic data, which causes the reaction of the economy to lag behind that of the stock market. The graph above shows the timing in which sectors have historically outperformed their peers, creating a timeline of which sectors do well in the various stages of the stock market and economic cycle.

Utilities generally perform better in an early bear market, while consumer durables perform better in a later bear market. Had you been overweight in discretionary goods, or another sector, throughout the COVID-19 market downturn, you may have increased your losses during the downturn and missed out on gains following recovery. This means that being overweight in one sector increases your risk, potentially leading to lost returns in both downturns and upswings.

Diversification as a Mitigation Tool

While one can try and time economic- and stock market cycles and allocate money to the historically best-performing sectors, accurately timing a future market downturn or upswing is notoriously hard. Instead, the obvious way to mitigate sector risk is by diversification, the benefits of which have been mentioned in many of our recent articles, including “ETF Investing – What Different ETFs Are There, How Do They Work?” and “Allocation Size - Don’t Have Lots of Insignificant Positions”. With diversification between sectors, one decreases the risk of sector risk by lowering the number of stocks that are correlated to one another, and thereby the chance of a downturn greatly affecting your portfolio’s value.

To check if you’re overweight in a sector, look at your portfolio holdings and see which corresponding sectors they belong to. If you hold ETFs or LICs, it’s worth taking a look under the hood to see what the sector breakdown is. If any sector stands out as a large portion of your portfolio value, you may want to consider diversifying further, with the simplest way being selling stocks in that sector or buying diversified ETFs.

The Takeaway

While it is often a good idea to invest in what you know, be wary if your investments are concentrated in one or a few sectors. Being aware of the nature of economic and stock market cycles elucidates the benefits of diversification in both upswings and downturns. However, simply trying to time the market according to these cycles is not advised. While some sectors may be doing well with above-average returns, if that sector experiences a downturn, it will dramatically decrease the value of a sector-concentrated portfolio. Moreover, losses loom larger than commensurate gains, so protecting yourself against concentration risk is valuable to your financial and emotional wellbeing.

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