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Is your portfolio overexposed?

Basking in the glow of recent profit results in the banking sector, it may seem odd to suggest paring back on these holdings, but bear with me.

Despite popular opinion, investments in Commonwealth Bank  (ASX: CBA)Westpac Banking Corporation (ASX: WBC)National Australia Bank (ASX: NAB) and ANZ Bank (ASX: ANZ) do not represent diversification. They tend to mirror each other’s share price movements, as they only differ slightly in exposures and product mix.

Although it may appear that our banks are invincible, business cycles come and go and companies are not immune to mistakes. The major risk for the future of banks is a recession. This would lead to a rise in unemployment (already underway) and a subsequent rise in bad debts.

The majority of investors hold the major banks to pocket excellent dividends and the associated franking credits. However, the majority of the broking community still see them as fully valued and lacking in growth avenues.

According to a report by the Australian financial services company Crowe Howarth Australia, investors should be prudent and consider trimming an overweight position. They have conducted a study from 2011 onwards, showing the banks to be less attractive now than in the preceding two to three years. Notably, yields have dropped from around 7% to under 5% and price-to-book ratios that are currently near or over 2 are not attractive for new investors.

What should investors do?

Often a stock with a lower yield that is growing dividends at a faster rate is a much safer bet. The banks may have to reign in dividends should bad debts take a turn for the worse, whereas a defensive stock such as Sonic Healthcare (ASX: SHL) may be preferable. Although trading on a lower yield, it has been able to grow dividends by 210% since 2002, and this growth is expected to continue in the future.

If you are holding a single major bank, Crowe Howarth suggests the others may be worth looking into, but it will be undertaken at the same high valuation you should be wary of. Despite the above-mentioned misgivings about diversification amongst the majors, intra-sector diversification is preferable to holding an overweight position in a single bank. Additionally, there is greater diversification to be obtained from investing in smaller banks such as Bendigo and Adelaide Bank (ASX: BEN) and Bank of Queensland (ASX: BOQ)

Foolish takeaway

While capital gains tax is an issue to be considered, one should neither make nor hold an investment based on tax reasons alone.

In my opinion, reducing overweight positions either for an individual bank stock or the banking sector as a whole is wise. Generally the best time to sell is when the market considers a sector invincible and overvalues stocks accordingly.

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Motley Fool contributor Mark Woodruff does not own shares in any of the companies mentioned in this article.

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