I can't imagine any scenario at this day and age where an investor hasn't been offered the opportunity to create a diversified portfolio, complete with a multi-colored pie chart. If you have a brokerage account, either your broker - or your appropriate website - has such a tool. And undoubtedly, the need for such an allocation has been preached to the point of disgust. It's a compelling case they make too - "Abide by our allocation, and you can't go wrong." On the surface it makes sense. After all, it never makes any sense to put all your eggs in one basket. In the same vein, doesn't it make sense to separate your eggs into as many baskets as possible? You'd think so, but a closer look at the reality of fully-diversified portfolios reveals some major short-comings of the strategy. Let's take a look at some of those problems that will eventually haunt you, if they haven't already.

First things first. Let's just define a diversified portfolio, just to be sure we're all on the same page. This isn't a definition set in stone....think of it as a philosophy. In essence, a diversified portfolio is one that roughly mirrors the overall market, in terms of sectors. There are ten major ones (according to Standard & Poor's), not counting the utilities and transportation stocks, which makes for twelve major market segments. But for the sake of argument, we'll just be looking at Standard & Poor's ten major ones. In general, each piece of that pie is about the same size as all of the rest. Some portfolios adjust the size of each sliver of pie based on a sector's market-weight, although the effects of doing that aren't all that significant. Your definition may vary slightly, which is fine. The specifics won't change anything you're about to read.

In the vast majority of allocation recommendations, there is one single typical rationale that an investor is given for buying into the diversification philosophy. That rationale? Since you don't know which sectors are going to lead the market in the future, the best choice is to own a little bit of each of them. On the surface it makes sense, and certainly alleviates the pressure on an investor to become a sector guru. And that pie chart makes it simple to adopt the plan. In fact, it's tough to justify doing anything else with a portfolio.

This is where investors start to rise - or not rise - to the occasion.

Just for the sake of argument, let's think about what's really going on here when your advice-giver tells you this is the only way to run your portfolio. Do they mean that you can't know what the next leading sectors are going to be? Or does it just mean that they don't know what the next leading sectors are going to be? If it's the former, and you have no desire to outperform the market, then the strategy is fine. If it's the latter, then maybe you should give their advice a serious second thought. It is possible to determine which sectors are poised to lead or lag. It's not necessarily easy to do, but it's possible. We'll be looking at how to spot sector leadership at a later time. For now, let's explore some the flaws of the full-diversification strategy.

It might sound a bit backwards, but let's begin with the end, so you know where this is all going. The key points you'll (hopefully) be taking away shortly are as follows.....

1) There are clear periods of time when it makes no sense to be holding a piece of all ten major sectors.

2) There are clear reasons why it sometimes makes sense to not own any stocks in any sectors. (A variation on the flaw of a 'buy-and-hold; mentality)

3) There is a clear bottom-line advantage to focusing on the sectors that will outperform, and a clear advantage in avoiding the sectors that are weaker.

Surprised? You're probably not alone. Most of what you've ever heard is close to the opposite of these three ideas. So how can anyone justify even thinking the opposite? As always, the flaws are best explained with real-life examples.

Over the last ten years (1995 through 2004)*...........

1) Never did more than 7 of the 10 major sectors outperform the S&P 500 (and that only happened once, in 2001).

2) On average, only 5 of the 10 major sectors outperform the S&P 500.

3) The one year that there were 7 sectors that beat the market, only the top two sectors actually produced gains. The other 8 sectors took losses (2001).

4) In one year, all 10 major sectors lost ground (2002).

5) In only 4 of the last 10 years did all 10 sectors make gains.

6) In 4 of the last 10 years, the bottom three performers took double-digit (percentage) losses.

7) The average gain for the top-performing sector each year was 42.0%. The average loss for the worst-performing sector each year was -11.2%.

8) The average annual gain of each sector that outperformed the S&P 500 each of the last 10 years was 23.4%. The average annual gain of the S&P 500 each of the same years was 12.0%.

(Data based on Standard & Poor's historical sector data, and provided my MFS Investment Management)

It stings a bit, knowing the difference between what was, and what could have been. Or at least it should. The heart-breaker is the last one........knowing that by sticking with the top-performers, you would have almost doubled the overall market return.

Is it easy to do? Can the average investor really determine which sectors are ready to lead, and which ones are going to fall behind? It's not easy. In fact, this may be the area that gets the most time and attention from our own research department. But then again, it's worth it - this is the area that can have the biggest impact on client's bottom lines.

But more importantly, it is possible for the average investor to do. It takes work and time, but it's not brain surgery. In fact, the real challenge isn't intelligence - it's discipline, and a little faith. Will the average investor accept the bigger sector trends that he or she has found? We do, and it's paid big dividends four our clients. But even if you don't pick sectors with pinpoint accuracy, tapping into half of performance improvement potential would bump your average annual gain up to 17.7% (splitting the difference in flaw #8). That would put you in the top performance percentiles of even the professionals.

Just for the sake of clarity, this is not an encouragement to do something irresponsible. No matter what, it's never wise to own less than four distinct sectors in your portfolio, and using five or six at a time would be considerably more prudent. It's also a bad idea to allocate more than 25 percent of any portfolio into one sector. With that in mind, if there aren't four good looking sectors to leave you 100 percent invested (at a maximum of 25 percent each), then don't do anything - just hold the cash until there is a viable opportunity. And if you need a reminder about whether or not history has rewarded those investors who knew when to be invested and when not to, or what sectors to be in or not, just review the eight diversification strategy flaws discussed a moment ago. There were periods where being involved in all ten sectors was a liability, and there were periods where being involved in any sector at all was a liability.

The question you need to ask is simply whether or not spreading yourself out as thinly as possible is going to actually help you meet your goals. If your goal is to beat the market, even if only by a little, will a nice-looking pie chart help you do that? Probably not. The reality is that if your portfolio is designed to 'mirror' the market in terms of sectors and allocation, odds are that your performance will also mirror the overall market returns. If you're ok with that, then the sector allocation becomes moot; just buy an index fund and leave it alone.

If indexing just isn't part of your world (which is fine), you may be among the majority of investors trying to create a market mirror with individual stocks. However, this doesn't alleviate the problem. This particular strategy includes a few related flaws:

(1) It assumes that the stock you pick from a particular sector will indeed be the sector leader,
(2) it assumes the stock you pick from a particular sector will actually rise, and
(3) to a smaller degree, it assumes that the stock or sector you've chosen actually offers a greater reward potential than the overall market (or an index) does.

See the problems? In the same order that the flaws were pointed out:

(1) The odds of actually picking a sector leader, or even one of the sector leaders, are lower than you'd like.
(2) We know that many sectors can and do lose ground, even when the market doesn't.
(3) We know that, on average, half of the ten sectors trail the market in any given year.

The hardest part here is acceptance. Sector concentration is the opposite of everything you're ever heard, and probably inconsistent with everything you're likely to hear in the future. However, as an investor you have the right - and the responsibility - to question everything. It is, after all, your money. Are your holdings spread out to protect you and give you a better chance at making some money? Or is that just a way for your financial advisor to keep your portfolio so busy that bottom line gains become secondary? The latter is more common than you may ever imagine.

As discussed above, this isn't permission to roll the dice and place some random bets on a sector or two. We're very careful about how we overweight sectors, and we always play defense once we're in a position. But we've also talked to a lot of investors who had been given beautiful presentations and allocation plans who have never actually made a dime with them. If you're one of those investors, perhaps now is the time to start taking a long and hard look at what works, and what doesn't.