Think Outside the Index When You Rebalance Your Investment Portfolio

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As the year winds down, it's common for investors to examine their portfolios and consider some rebalancing. This means looking at your investments to make sure you're not over-invested or underinvested in certain areas.

Many investors will simply buy shares of a mutual fund that mirrors the performance of the S&P 500. You can do well with this simple approach, but you will lack exposure to many smaller or midsize companies, and will be heavily invested in some industries (such as technology) but not others.

Here are some sectors and asset classes that you can invest in to make your portfolio truly diverse.

1. Utilities

They aren't the sexiest investments, but this sector contains many great dividend stocks that can boost your income while offering the stability your portfolio might need. Consider that during the market tumble between 2007 and 2009, the S&P 500 lost about half its value, while the Dow Jones Utility Average index lost about one third.

Right now, utilities make up around 3 percent of the S&P 500, so many investors don't have much exposure. Consider mixing in some utilities by investing in mutual funds like the Vanguard Index Utilities Fund [VUIAX] or ETFs such as the iShares Global Infrastructure ETF [IGF].

2. Materials

This is another underappreciated sector that deserves more love from investors. What are "materials" in stock market lingo? This refers to companies that discover and process raw materials. Think of steel manufacturers, mining companies, or chemical producers. The materials sector also makes up about 3 percent of the S&P 500, but has outperformed the broader stock market over the last year. Materials also outperformed the S&P 500 during the Great Recession.

Well-performing materials mutual funds include Vanguard Materials Index Fund [VMIAX] and the Fidelity Select Materials Portfolio [FSDPX].

3. Telecommunications services

This sector includes companies such as Verizon, AT&T, and T-Mobile. Companies like these have not been the best performers in recent years, but they can bring stability to your portfolio and offer a very healthy dividend yield. Investors might earn an annual dividend of 5 percent or more with these stocks, which is helpful income during this time of low interest rates. Older investors who are willing to sacrifice growth for income and stability may want to take a hard look at telecom services, which currently make up about 2 percent of companies in the S&P 500.

4. Energy

This sector comprised more than 10 percent of the S&P 500 as recently as three years ago, but that's down to about 6 percent now. That's a shame, because the sector includes some very strong companies including ExxonMobil and Chevron. It's been a very volatile few years for the energy sector due to the tumble in oil prices, but there are bargains to be had, and the world is not going to cease demanding energy, especially from developing countries. Investing in green energy can offer some growth opportunities, and you'll be helping the planet in the process. Energy stocks can also offer higher dividend yields than many sectors.

5. Consumer staples

This sector likely has some of the most familiar stocks you can think of. Currently making up over 8 percent of the S&P 500, consumer staples includes firms like Coca-Cola, Procter & Gamble, Unilever, and Walmart. And yet, this sector is somewhat underrepresented in the S&P 500. This sector is considered a safe haven for investors, because it often performs better than other sectors during times of market uncertainty. That's because even during the worst of times, we all still need basic household products. This sector also has an average dividend yield of nearly 3 percent, making it attractive to income investors.

To get more exposure to consumer staples, take a look at ETFs such as the iShares Consumer Goods ETF [IYK] and Vanguard Consumer Staples ETF [VDC].

6. Small cap stocks

When you invest in the S&P 500, you're investing only in the largest companies. These companies may offer solid returns, but it's never good to be invested too heavily in companies of a similar size. To build a truly diversified portfolio, it helps to invest in a healthy dose of smaller companies as well. Small cap stocks are generally those with market capitalization between $300 million and $2 billion. These firms tend to be more volatile, but their gains can be more dramatic. Consider that the T. Rowe Price Small Cap Fund [OTCFX] has averaged a return of around 20 percent over the last year, compared to about 16 percent for the S&P 500. Small cap value stocks — comprised of small companies generally considered undervalued by fund managers — have performed even better over the last year.

7. Mid-cap stocks

Not too big and not too small, mid-cap stocks include some very well-run companies in a wide range of industries, and they can bring growth and stability to your portfolio. If you want to invest in midcaps, forget the S&P 500 and go with the S&P 400, which includes the top mid-sized companies and routinely outperforms the smaller and larger asset classes.

The Vanguard MidCap ETF [VIMSX] has seen a 10 percent annual return since 2004, and the T. Rowe Price Midcap Growth Fund [RPMGX] has seen a 13 percent annual return since the early 1990s.

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