Market sectors are a group of industries that have broadly defined commonalities. Companies within a given sector are in the same economic field or business type. The term "sector" can be relatively confusing because it is sometimes used interchangeably with "industry," which implies a greater similarity among the businesses in the category.
The easiest way to understand the difference is to look at the Global Industry Classification Standard (GICS), which is used by Standard and Poor's as a primary reference for referring to market sectors. The four levels are:
- Sectors – The broadest definition. There are ten market sectors: Energy, Materials, Industrials, Consumer Discretionary, Consumer Staples, Health Care, Financials, Information Technology, Telecommunication Services, and Utilities.
- Industry Group – The next categorization below sectors. For example, under Financials, the listed industry groups are Banks, Diversified Financials, Insurance and Real Estate (although Real Estate is often considered as a separate sector). There are currently 24 industry groups across the ten sectors.
- Industries – A further refining of industry classifications. For example, under Information Technology Sector, Software & Services industry Group, the choices are Internet Software and Services, IT Services, and Software. There are 67 industries across the 24 industry groups.
- Sub-Industries – The most narrow classification. For example, under the Software industry above, there are three sub-industries: Application Software, Home Entertainment Software, and Systems Software. There are currently 156 sub-industries across the 67 industries.
There are other classification systems, but they follow the same basic format – ten to twelve sectors broken down into increasingly similar sub-groups.
As you look into sector investing, especially with sector funds, make sure you understand which level of the market you are dealing with. Funds are usually labeled correctly as sector or industry-targeted, but it is best to verify.
Why is this important? Because the similarities within a group get stronger going from sectors toward sub-industries, and so funds in these categories tend to be less diverse and have similar risks and rewards. That may be what you want, if you are bullish on one particular field – but understand your true level of diversification.
How can you use sector investing to your advantage? That depends on your goals. Are you trying to maintain diversity, maximize returns, or do you have another objective?
One popular method of sector investing is to use sector rotation, which is altering your portfolio by sector based on the current economic business cycle to maximize return.
For example, during contraction and recovery phases, discretionary spending is down and therefore sectors like consumer discretionary and financial are less desirable. Conversely, sectors like Energy, Utilities, and Consumer Staples tend to be stronger in difficult times – because everyone still has to eat, drive and stay warm. During growth and peak phases, Consumer Staples and Financial sectors tend to be favored.
Others prefer to analyze and pick winners within a classification, looking for information that a specific company will outperform its peers. A company stock that is out of sync with its classification, either positively or negatively, deserves attention and analysis.
Still others prefer to target sector or industry funds that are professionally managed. The fund may be designed to provide diversity within a particular industry or sector, or it may be designed to maximize growth.
Sector and their sub-classifications can be used as investments guidelines, methods of comparison, or measures of diversity. They are tools, and like any other tools, they can be used to build something or dismantle something. A proper understanding of market sectors will help you successfully follow any investing strategy that you choose independently, or in consultation with your investment advisor.