How Sectors and Industries Guide Investors

 

Sectors and industries help investors understand what they’re buying. That’s a prerequisite for anyone who wants to buy sound investments, observe market turmoil without panicking, act when it’s needed, be successful more often than not with their decisions, and live with a lot less stress.

In a nutshell, sectors are categories used to group companies that share similar types of business activities. Sectors are further divided into industries, also called sub-sectors) to group companies that are even more similar to one another.

Learn how to build a recession-proof portfolio! Download our free workbook.

What do we buy when we invest?

Whether we invest in stocks or equity ETFs, we buy shares of businesses that sell a multitude of products and services—from microchips to potato chips, medications to vacations, banking to trucking. Some of these, we buy all the time (food, electricity). Others, only once in a while (haircuts, appliances, restaurant meals), and some, we’ll splurge on when the economy is strong, and we feel confident and secure (cars, trips).

When things go south, we buy more of some things but less (or none) of other things. Remember the pandemic? Not a lot of spending on theatre tickets or haircuts, but did we ever order stuff online for our comfort at home and, oddly, toilet paper. I laughed out loud reading that online clothing vendors were selling disproportionate quantities of tops compared to pants while people were at home, sitting through meetings via videoconferencing.

Some go up, some go down

Depending on what they sell, some businesses are stable pretty much all the time, others thrive in booms, while others are remarkably resilient during bad times. Sectors and industries help us to spot which companies have which attributes, therefore, to choose holdings to diversify our portfolio. Diversification ensures we always have enough investments that are poised to do well or to at least bring stability, regardless of the state of the economy. In other words, sectors make it easier to not put all our eggs in one basket.

The sectors 

The widely recognized Global Industry Classification Standard (GICS) divides the economy into 11 sectors, each containing companies with similar business models and production processes.

  1. Pie chart divided in 11 equal parts, each one representing a sectorEnergy: Exploration, production, and marketing of oil and gas.
  2. Materials: Extraction and processing of raw materials, e.g. metals, chemicals, and forestry products.
  3. Industrials: Construction, machinery, fabrication, manufacturing, defense, and aerospace. Covers a wide range of businesses.
  4. Consumer Discretionary: Goods and services for which demand varies significantly with income levels or economic conditions, e.g., cars, hotels, restaurants, leisure facilities, and luxury goods.
  5. Consumer Staples: Goods and services used daily, e.g., food, beverages, and household products; essential goods for which demand is pretty stable regardless of economic conditions.
  6. Health Care: Healthcare equipment and services, pharmaceuticals, biotechnology, and related life sciences.
  7. Financial Services: Banks, investment funds, insurance, and asset management.
  8. Information Technology: Software, hardware, semiconductors, and services related to information technology.
  9. Communication Services: Telecommunications, media, and internet service providers.
  10. Utilities: Essential services, i.e., water, electricity, and gas, and renewable energy providers.
  11. Real Estate: Real estate management and development. Includes real estate investment trusts (REITs).

Sectors group companies that are quite different from one another, sometimes wildly different. What do Starbucks and Home Depot, both in the consumer discretionary sector, have in common? How about Canadian National Railway (CNR.TO) and HR and payroll technology provider ADP in the industrial sector? That’s why sectors are divided into industries.

Diversification through sector allocation

I believe you should never invest more than 20% of your money in a single sector. The more you exceed 20% in a sector, the more volatile your portfolio can become. When the market drops, it affects all sectors, but each crisis is most damaging for a subset of industries. Unfortunately, we never know which will suffer the most. Diversification equals protection!

Below, we see the sector allocation of a portfolio containing 9 sectors, one of which is slightly overweight.

Pie chart showing a portfolio's sector allocation with the information technology sector slightly overweight at 23.54%.

Because of the variety within sectors, it’s possible to have over 20% of your portfolio in, let’s say, the industrial sector, and still be well-diversified. For example, you might have a company in aerospace & defense, one in building products, one in railroads, and one in tools and accessories. All are in the industrial sector, but building products have little to nothing to do with the defense industry.

Invest in several sectors, but not necessarily in all of them. Some are more volatile than others, some have growth potential but don’t produce the largest dividend income, and others provide more stability and income. So, depending on what you’re looking for, you might want to have more of your portfolio in some sectors than others. For more details, see Composition of your portfolio.

For a deep dive into each sector, including strengths and weaknesses, the role each plays in a portfolio, and appropriate weight for different types of investors, and much more, download our Recession-proof portfolio workbook below:

Who decides which sector a company belongs to?

Why is a stock like Dow (DOW) in the materials sector rather than industrials? Why is Visa (V)  in the financial sector rather than information technology? Because some companies qualify for more than one sector. Look at Visa and Mastercard:

  • Both process payments, so it makes sense that they’re in the financial services sector.
  • Their strengths reside in their network and technology, and they’re not on the hook for consumer debt; the banks issuing the credit are. So, they could be considered technology stocks.
  • Both depend on consumer spending to generate their revenue. During recessions, consumers spend less on travel and cross-border shopping—both great revenue sources for them. One could also argue they belong in the consumer discretionary sector.

If your portfolio is overweight in the financial sector but has a 5% position in Visa,  you could review your allocation considering Visa to be 1/3 technology, 1/3 discretionary, and only 1/3 financial.

Since we can’t attribute multiple sectors to one company, we adopt the commonly accepted classification provided by Refinitiv, a London Stock Exchange company.

A company’s sector attribution can change as business models and the economic environment change; Disney moved from consumer discretionary to communications, and Amazon from information technology to consumer discretionary.

In closing

Sectors and industries are useful guides for investors to build a diversified and resilient portfolio. Be aware of each sector’s strengths and potential downside However, fully understanding the business model of each company you hold or like also helps you assess your portfolio’s level of volatility.

The post How Sectors and Industries Guide Investors appeared first on The Dividend Guy Blog.

Leave a Reply

*