Sector investing.

Understanding industry sectors and their role in diversifying your portfolio

Investors who loaded up on tech stocks before the market crashed last fall learned a painful lesson: "Don't put all your eggs in one basket." Whether you're an aggressive take-no-prisoners sort of investor or the mild-mannered, conservative type, everyone needs some diversification in his or her portfolio. You ought to build up several baskets of stocks in different industry sectors.

The universe of publicly traded companies is broad, with more than 36,000 stocks trading on the market. But there are hundreds of industry sectors, ranging from auto parts to books to restaurants to telecommunications services. There are even subsectors, such as pharmaceuticals within health, computers within technology, and footwear within retail.

Unless you can withstand the greatest level of risk both financially and psychologically, never concentrate exclusively on one sector. "Regardless of how strong a sector's revenue growth and earnings may be, there's no need to expose yourself to that kind of concentrated risk--short-term or long-term," advises Dave Kansas, author of TheStreet.Com Guide to Smart Investing in the Internet Era (Doubleday, $24.95).

Steven L. Sanders, president and co-CEO of Philadelphia-based MDL Capital Management, a money-management firms, suggests you start with the sector within which you work. "If you work in retail, you know how much foot traffic there is; you can size up the mall; you can watch shoppers' spending habits. This is great sector research," he explains (see "Investing in What You Know," July 2001).

Ideally, says Sanders, you want to pick the best company or two within your favorite sectors. Then determine what percentage of your portfolio you want in each sector.

HOW MANY STOCKS TO OWN?

Diversification doesn't mean owning a lot of stocks. It means making sure your portfolio is balanced with stocks from across the industrial spectrum. "A portfolio of a dozen or so stocks should provide you with both the protection of diversification and the focus to build wealth in the market," says Kansas.

S&P 500 Industry Group Representation

                             Number of Companies   Number of Companies
                                                   as % of S & P 500

Consumer Discretionary              85                   17.0%
Consumer Staples                    37                    7.4
Energy                              26                    5.2
Financials                          70                   14.0
Health Care                         71                   14.2
Industrials                         40                    8.0
Information Technology              77                   15.4
Materials                           41                    8.2
Telecommunication Services          13                    2.6
Utilities                           40                    8.0

The simplest way to invest in various sectors at one time is to own mutual funds. But for individual stock pickers, Kansas recommends you "choose a few stocks that are likely to produce above-average returns over the long haul, concentrate the bulk of your investments in those stocks, and have the fortitude to hold steady during any short-term market gyrations."

TOOLS FOB SECTOR ANALYSIS

There are several resources to help you analyze sectors. StockCharts.com provides charts that show the performance of the S&P 500 by industry sectors. MarketGuide.com lists 102 industries sorted daily by performance. It also includes links to companies in each industry.

Once you determine which sectors interest you, it will be easier to locate the best performing companies in those sectors. Several Websites rank stocks within a given sector. Check out their financial screening tools, which will scan for stocks that meet your criteria. You can also screen for stocks using industry indexes, sector listings, and industry listings.

Compare your level of diversification to the sector composition of the Standard & Poor's 1500 SuperComposite Index, a combination of the S&P 500, S&P Midcap 400, and the S&P Small-cap 600 at www.spglobaldata .com/spgi/spgi5.wsx, which gives the performance of each sector over various periods of time, from one month to one year. Other indexes are the Russell 1000 and Russell 3000 (www.rus sell.com), which are made up of large-cap stocks.

"Before you actually pick any stocks, look at how those indexes are weighted; what percentage each sector contributes. Then look at which companies are in those sectors," Sanders says. This way you can better measure your success, especially in a down market. Investors get a false sense of their stock-picking prowess during up markets. If your approach is right, when stocks in one sector of your portfolio are down, others will be thriving. Adds Sanders, "Let asset allocation and diversification work for you through sector investing."