Both the financial and telecommunications sectors have provided investors in the Australian share market with substantial capital gains and dividend income in recent years. However, in the process many investors may now be holding an unbalanced share portfolio that could suffer disproportionally either in the event of a sector reassessment by the market or a general market fall.

In maintaining a balanced portfolio of Australian shares, attention should be paid to diversification. The intent of diversification is to allow the positive performance of some asset classes to neutralise the negative performance of others. For investors, this requires more analysis than simply spreading your investments across 20 stocks.

Using the financial sector as an illustration, many investors may have been investing in all four of Westpac Banking Corporation (ASX: WBC), National Australia Bank (ASX: NAB) ANZ Bank (ASX: ANZ) and Commonwealth Bank (ASX: CBA). This is the antithesis of diversification, as over time they are almost perfectly correlated. Yes, there are times when analysts have their preferred bank, but over time the share prices move in unison.

Telstra vs the banks

If you have over-allocated toward banking stocks, how can you rebalance? I empathise with those who have fallen in love with stocks, and selling them is possibly the hardest psychological decision one must confront.

To assist in this process, a dispassionate appraisal of the long-term prospects of both the telecommunication and banking sectors may be of benefit.

On a pure comparison of yield, Telstra (ASX: TLS) is currently on a gross of 7.6%, while investors may still acquire banks with a gross of 7.0%. In a market downturn or simply a re-assessment of sector prospects, the full 7% may be lost courtesy of a falling share price.

The recent bank profit reporting season has revealed some significant headwinds for the banks. The Australian Prudential Regulation Authority (APRA) has instructed Australia’s banks to hold far greater than expected capital reserves, which will limit dividend payments to shareholders.  Additionally, as reported in the Australian Financial Review, there will be a double-whammy hit to profits from higher individual charges for bad debts and higher collective provisions should the economy turn down.

Alternatively, tailwinds in the form of an expanding mobile business, cloud computing and Asian expansion are benefiting Telstra. It has also pre-empted an increase in dividends over time. Finally, should the share market retreat, Telstra is increasingly being viewed as a pseudo utility stock that would likely be well supported in a market downturn.

Foolish takeaway

Consideration should be given to the effect of correlated shares in your portfolio that may be undermining your actual diversification.

Banks shares have served investors extremely well over a long period of time and dividend yields should provide some measure of support during a market fall or sector rerating, assuming that payout ratios are not reduced. However, for a variety of reasons, Telstra is looking the preferred holding for the longer term.

All of the above is making the assumption that the investor is not already overweight in the telecommunications space, by dint of either the swelling value of existing holdings in Telstra or additional investment in such stocks as TPG Telecom (ASX: TPM), iiNet (ASX: IIN) and M2 Telecommunications (ASX: MTU). 

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Motley Fool contributor Mark Woodruff owns shares in Telstra.