You can develop your own diversified investment portfolio by spreading your holdings out over the main economic sectors, looking for high-quality companies and more

A little while ago, I exchanged investment ideas with an acquaintance who has worked in the investment business for the past several decades. After I explained how we choose stocks to recommend and how we manage client portfolios, he said, “I completely agree! I diversify for each one of my clients. My view is that if you buy a bunch of different stocks, one of them is bound to pop.”

Many investors would no doubt agree. However, it takes more to succeed than just a diversified investment portfolio. If you just buy a bunch of different stocks, you may wind up with a grab bag of duds. But even if you stick with high-quality stocks, you may find that many of them respond to, or are vulnerable to, one particular type of risk. If this one factor moves against you, your entire portfolio can suffer.

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Employing the five-sector approach to your diversified investment portfolio

This five-sector approach (Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities) was common in the first half of the 20th century. I often heard about it in the 1970s, from a number of successful investors I met early in my career. Their views and the success they achieved had a big role in shaping my investment ideas.

Oddly enough, the five-sector approach was already on its way out when I first heard about it. That’s because it didn’t fit the needs of the investment industry.

The problem is that as technology advances and the economy changes, the five-sector system forces its users to make judgment calls. For one thing, more companies become active in multiple sectors. Major investment firms and stock exchanges prefer systems that don’t allow for judgment calls, much less demand them. That makes it simpler to judge performance and set pay grades for the hundreds of analysts and fund managers who work for these institutions.

We have a different goal. We focus on helping investors build portfolios that generate attractive returns over long periods, and avoid deep downturns during market setbacks.

We‘ve refined the approach over the years, but it still bears a close resemblance to the rule I first heard about years ago. We’ll stick with it until we find a better tool for managing investments and limiting risk.

Four ways to ensure a diversified investment portfolio

• Your portfolio strategy should begin with a fundamental piece of advice that we underlined above. Spread your money out across most if not all of the 5 main economic sectors (Finance, Utilities, Manufacturing, Resources, and the Consumer sector). The proportions should depend on your objectives and the risk you can accept. The Canadian Finance and Utilities sectors involve below-average risk. Manufacturing and Resources tend to be riskier, and the Consumer sector is in the middle.
• Balance aggressive and conservative investments in your portfolio, in line with your investment objectives, and the market outlook. Above all, avoid the urge to become more aggressive as prices rise and more conservative as prices fall.
• Market leaders and market laggards both deserve a place in your portfolio. Over long periods, high-quality stocks play leapfrog. Some of the lowest-risk, highest-profit buys you’ll ever find are overlooked or out-of-fashion stocks of high investment quality that are coming back into investor favour.
• Good portfolio management also means balancing your investments geographically. Avoid focusing your portfolio on any one country or region. A lower-risk way to add international exposure to your portfolio is to hold multinational U.S. stocks, such as IBM, McDonald’s and Wal-Mart, which invest overseas as well as domestically. We cover all three of these companies in our Wall Street Stock Forecaster

Adding ETFs to your diversified investment portfolio

We still feel that investors will profit the most with a well-balanced portfolio of high-quality individual stocks, but ETFs can also play a role in a portfolio. For instance, we think conservative investors could hold up to 10% of their portfolios in foreign stocks. One way to do that is to buy carefully chosen exchange traded funds (ETFs) that have an overseas focus.

The best ETFs offer very low management fees and well-diversified, tax-efficient portfolios of high-quality stocks.

Don’t forget to add dividend-paying stocks to your diversified investment portfolio

Even though the best dividend stocks can be your most profitable investments, dividends rarely get the respect they deserve, especially from beginning investors. That’s because a dividend-paying stock’s yearly 2% or 3% or 5% yield barely seems worth mentioning alongside yearly capital gains of 10%, 20% or 30% or more.

Good dividend stocks are a valuable component of any sound investing portfolio.

What are the sectors you have found the most investing success with?

How do you approach building a diversified investment portfolio? Do you draw from the five economic sectors, or do you have a different strategy?