What is Industry Diversification?

Events that affect one industry as a whole may have the opposite effect - or no effect at all - on another industry. Take the outcome of OPEC meetings, for example. Any one decision could impact the price of oil, which is the most significant contributor to airline costs. So if oil prices go down, oil companies will suffer, but airlines will benefit.

Let's say OPEC has decided to ramp up oil production in an environment where supply is already high. This increase in supply would, in most cases, translate to lower oil prices. In this scenario, if you're only exposed to oil, you'd take a pretty large loss. But if your portfolio had some airlines exposure in it, gains there would soften the blow on your oil loss. And if your portfolio was composed of many other industries that aren't as sensitive to oil price changes, then your losses would also be smaller. This is all to say that the greater your exposure to a single industry, the more likely you are to be negatively impacted by an event affecting that industry.

Of course, relationships between other industries can be a lot less clear and much more nuanced, but this example illustrates an important point that: the best way to protect yourself from the impact of market events like this one is to diversify your industry exposure.

P.S. Watch out for Familiarity Bias!

Investors tend to be overweight sectors and industries they are the most familiar with. This often leads them to under-diversify and be overexposed to only a few industries, which can potentially be catastrophic. 

We can't stress enough how important it is that you be mindful of this bias in your portfolio. Remember to consider industries and sectors you may not be totally familiar with and minimize your risk exposure by diversifying your portfolio composition.

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What is Geopolitical Exposure?

What is Geographical Diversification?