Speaking of Stock Portfolios

[adios]

How do you select your portfolio? A hypothetical example, if your portfolio consisted of only drug companies your portfolio wouldn't be that diverisified in that drug companies tend to move together (covariance is high). You would probably look for some index or mutual fund that held drug companies instead of buying individual stocks. This would probably lower transaction costs and probably enhance the risk-reward tradeoff. However, you might feel that drug companies in general are undervalued and trade them actively by selling the expensive ones in the group and buying the cheap ones. Most traders I know do this more or less. Identify sectors that they feel they know well and for lack of a better term trade "the crap of of em" i.e. they sell what they perceive as expensive relative to the group and buy what they perceive as cheap. Also most traders I encounter form some sort of long term economic view and make their choices accordingly. They know a few sectors well and decide how they fit into the econimic view that they have.

[player24]

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you might feel that drug companies in general are undervalued and trade them actively by selling the expensive ones in the group and buying the cheap ones

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Your alternative is to buy the cheap sectors and sell the rich sectors. By pairing longs and shorts within a cheap sector (diagonal pairs trading), you are cancelling out a potentially profitable sector bet (assuming you are net flat the sector). I would tend to trade diagonal pairs (cancelling out my net sector exposure)in sectors for which I lacked any broad conviction, rather than in sectors which I believe are cheap (good long candidates) or rich (good short candidates).

Of course, alot has to do with your portfolio objectives and your particular skills - some people are good at playing broad sector themes, but terrible at picking individual stocks.