You Can Diversify Your Portfolio by Investing All Your Money in One Industry?

Spreading investments across different assets is a common strategy to reduce risk, but some investors believe they can achieve diversification even within a single industry. This assumption is based on the idea that companies in the same industry operate differently enough to balance a portfolio.

However, true diversification depends on how investments respond to market conditions. If all holdings are influenced by the same economic forces, risks may be greater than expected. Understanding how industries behave within broader markets is essential to assessing whether this approach effectively manages risk.

Distinguishing Sectors and Industries

Financial markets classify businesses into sectors and industries to help investors compare companies with similar revenue drivers. Sectors represent broad economic categories like healthcare, technology, or consumer discretionary. Industries further divide these into specific business activities. For example, the technology sector includes semiconductors, software, and IT services—each with distinct business models and risk factors.

A pharmaceutical company and a hospital both belong to the healthcare sector, but their financial performance depends on different factors. Drug manufacturers rely on research and development, regulatory approvals, and patent protections, while hospitals focus on patient volume, insurance reimbursements, and operational efficiency. Even within the same sector, companies face unique challenges.

Stock market indices and exchange-traded funds (ETFs) often follow sector classifications to track performance. The Global Industry Classification Standard (GICS), used by major financial institutions, divides the market into 11 sectors and over 100 industries. This system helps investors analyze trends, such as how rising interest rates impact real estate investment trusts (REITs) differently than homebuilders, even though both are part of real estate-related industries.

Correlation in Single-Industry Holdings

Investors concentrating their portfolios within a single industry often assume that selecting companies of various sizes or business models provides enough diversification. While these differences may create some variation in returns, the key issue is how closely these companies move together in response to industry-specific events. Correlation measures the degree to which asset prices move in relation to one another, and within a single industry, this relationship tends to be strong.

For example, in the airline industry, companies like Delta, American Airlines, and Southwest have different cost structures and route networks, but they are all sensitive to fuel prices, travel demand, and economic cycles. When oil prices rise sharply, all airline stocks typically decline due to increased operating costs. Similarly, during a recession, discretionary travel spending falls, negatively impacting revenue across the industry. Even budget carriers and premium airlines, despite their different strategies, often experience similar stock price movements because they share the same fundamental risk exposures.

Beyond industry-specific risks, broader economic factors can also amplify correlation. Interest rate changes, regulatory shifts, and supply chain disruptions can affect an entire industry in ways that make diversification within that space difficult. Semiconductor companies, for instance, may serve different end markets—some focus on consumer electronics, others on automotive or data centers—but they are all influenced by global chip demand, government policies on trade, and technological advancements. If a major geopolitical event disrupts semiconductor supply chains, nearly all companies in the industry will likely see declines, regardless of their individual business models.

Accounting for Concentrated Positions

Managing a portfolio heavily weighted in a single industry requires careful attention to financial reporting, tax implications, and risk mitigation strategies. One challenge is valuing holdings, especially when a significant portion consists of illiquid or restricted shares. Investors with large positions in a single company, such as founders or early employees, often face limitations on selling shares due to lock-up periods, insider trading restrictions, or corporate policies. These constraints can lead to valuation discrepancies, especially if market conditions shift before shares can be liquidated.

From an accounting perspective, concentrated positions can introduce volatility in financial statements. Fair value measurements under Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) require periodic reassessments, which may cause fluctuations in reported net worth. When holdings represent a dominant share of an investor’s assets, impairment losses or revaluation adjustments can significantly impact financial statements. For businesses or funds holding concentrated positions, these swings may affect covenant compliance on loans, investor confidence, or regulatory reporting requirements.

Tax planning is another major consideration. The U.S. tax code imposes capital gains taxes on the sale of appreciated assets, with rates varying based on holding periods. Long-term capital gains are taxed at 0%, 15%, or 20% depending on income levels, while short-term gains are subject to ordinary income tax rates, which can be as high as 37% in 2024. Investors with substantial unrealized gains often use strategies such as charitable remainder trusts (CRTs) or exchange funds to defer or reduce tax liabilities. CRTs allow donors to contribute appreciated securities to a trust, receive income distributions, and defer taxes on gains, while exchange funds enable investors to pool concentrated holdings with others to achieve diversification without triggering immediate taxable events.

Liquidity management is also important when dealing with concentrated positions. A sudden need for cash can force investors to sell shares at inopportune times, potentially realizing large tax liabilities or depressing stock prices if the position is sizable relative to the company’s trading volume. Structured sales, such as Rule 10b5-1 trading plans, allow insiders to prearrange sales at predetermined intervals, reducing the risk of market impact while ensuring regulatory compliance. Hedging strategies, including equity collars or prepaid variable forward contracts, can provide downside protection while monetizing portions of a concentrated holding without outright selling.