The basis for sector investing is diversification. This is amongst the first set of general rules that most professional investors would advise beginner investors to follow. Sadly this advice is all too often ignored. Diversifying across the various sectors lowers the overall risk that the investor is exposed too.
Investors often build up their portfolios over a period of time by purchasing stocks that are familiar corporations such as Yahoo or Wal-Mart or they buy stocks that are currently making the financial news headlines. This typically leads to investors owing stocks in only a couple of sectors which increases risk. If the investor’s returns are tied to only a couple of sectors and one of those sectors performs poorly then the entire portfolio will produce poor returns. It’s a case of not putting all your eggs into one basket. While there are good reasons for buying certain stocks in certain sectors, the issues of risk should always be addressed.
The premise for sector investing is to look at the various sectors and select the stocks accordingly.
Example 1.
As an example, an investor might own an airline stock such as Spirit Airlines, Inc.
A mid-East crisis might send the price of oil soaring which will lower the profits of Spirit Airlines, Inc.
But if the investor also owns an oil stock such as Exxon Mobil Corp. then the risk is balanced as the oil company’s profits will increase as the airline company’s profits fall.
As a very general rule, the stock prices often move in the same direction for the stocks making up the sector. This because the economic conditions that affect one stock in the sector will often also affect the other stocks in the sector. For example, if the rising oil price affects one airline stock, then the rising oil prices will not only affect the other airline stocks, but also affect other transport companies in general.
Example 2.
As another example, if an increase in labor costs in the manufacturing industry affects Ford, then the increased labor costs will not only affect the other car manufactures but also affect the whole manufacturing industry in general.
Industry Classifications
There are numerous standard industry classifications used within the U.S. stock markets to organize companies into groups which are generally referred to as sectors.
The three main classifications commonly used in financial reporting are ICB, GICS and TRBC. These three are very similar to each other. While there are other classifications, they tend to be more used by economists rather than for financial reporting and market analysis.
Industry Classifications:
- The Industry Classification Benchmark (ICB) was developed by Dow Jones & Company, Inc. and the FTSE International group. The ICB classification groups companies into 10 broad groups which the ICB refers to as Industries.
- The Global Industry Classification Standard (GICS) was developed by MSCI inc. (Morgan Stanley Capital International) and Standard & Poor’s (S&P). The GICS classification groups companies into 10 broad groups which the GICS refers to as Sectors.
- The Thomson Reuters Business Classification (TRBC) was developed by Thomson Reuters. The TRBC classification groups companies into 10 broad groups which the TRBC refers to as Economic sectors.
The 10 main sector groups for the ICB, GICS and the TRBC classification systems are shown below in Table 1.
Table 1. ICB, GICS and TRBC sectors
Note that the ICB classification refers to Sectors as Industries.
Sector Balance
Sector investing does not mean that a portfolio needs to be balanced evenly across all ten sectors, but it is a good idea to have exposure to all or at least most of the ten sectors.
Example 3.
For example, in times of economic slowdown, investors may weigh their portfolio more heavily into the Defensive sectors such as Consumer Staples or Utilities.
Companies such as Food Retailers/Producers and Utility companies are less affected in recessions since consumers still require their products as a necessity.
- Food Retail Companies such as Casey’s General Store, Inc. or Ingles Markets, Inc.
- Food Products companies such as J.M. Smucker Co. or Tyson Foods, Inc.
- Electricity Utility companies such as Allete, Inc. or Empire District Electric Co.
- Gas Utility companies such as Southwest Gas Holdings, Inc. or Atmos Energy Corp.
- Water Utility companies such as American Water Works Co, Inc. or Aqua America inc.
Even in a recession people still need to eat and they still need electricity, gas and water.
The long-term outlook for each sector should be considered but here the view becomes quite hazy. Sometimes the outlook is more obvious over the short-term such as an impeding recession that will see the Consumer Staples and Utility sectors coming into favor. The long-term for some sectors is more obvious such as with the Technology sector where consumers have an appetite for the latest gadgets to make life more enjoyable.
Stocks vs. Funds
A common investing tactic is to buy a sector fund and thus spread their risk across the whole sector rather than with one or two individual stocks. Note that the investor cannot buy a sector; they can only buy a fund that tracks the sector.
The investor can buy individual stocks or they can buy a fund (such as an ETF) over the sector. Each have their advantages and disadvantages and the investor can always buy both stocks and sector funds.
Holding Stocks:
- The investor can choose the stocks they would like to hold for each sector.
- There are no ongoing fund management fees.
- The investor gets the personal satisfaction of being a part owner of the company.
Holding Funds:
- The sector is truly diversified as funds tend to own a large number of stocks within the sector.
- The performance of the fund reflects the performance of the sector.
- Funds charge fees including annual fees which can be quite high (5% or higher). These costs adversely impact on the portfolio’s returns.
There are numerous ETF providers and the providers tend to specialize in certain markets. The following three ETF providers: SPDR, iShares and Vanguard – have ETFs available for all the sectors (with the exception of SPDR which does not provide a Telecommunications ETF). These ETF providers are summarized below in Table 1. (table data: Mar 10, 2017)
Table 2. Sector ETF Providers
Table data: Mar 10, 2017
There are other ETF providers that cover some of the sectors or have ETFs that broadly cover an industry group but do not fully cover the whole sector.
How many stocks to hold
For the investor who wants to hold stocks, the question is how many stocks should the investor hold in their portfolio.
The opinions do vary but generally between 10 and 20 stocks spread across all or most of the 10 sectors. If the investor only holds 10 stocks this generally means holding only one stock from each sector. Holding less than 10 stocks increases the risk as there are some sectors that the investor has no exposure too.
Holding more than 20 stocks generally increases the amount of work in managing the portfolio and while only slightly reducing the risk any further. Thus it’s extra work without really providing any more diversification. However a long-term buy and hold investor could hold more since they generally spend very little time with the ongoing portfolio management.
The advantage of holding 20 rather than 10 stocks is that the investor can skew the weighting of their portfolio in favor of the stronger sectors and thereby potentially increasing their returns while still having a diversified portfolio. For Example, during an economic recession the investor hold more Consumer Staple and Utility stocks and reduce the number of stocks held in the other sectors.
The only way an investor holding 10 stocks can skew their weighting is by reducing or increasing the number of shares owned in each stock. The investor holding 20 stocks can also alter the number of shares owned and they have the advantage of being able to add additional stocks to select sectors.