Demystifying Market Sectors

With all of the hoopla over various stock indices, it is sometimes easy to forget that the stock market is a market for individual stocks and not a singular entity that eats fortunes.  These stocks are not merely little pieces of paper (or the digital equivalent); they represent discrete pieces of ownership in living, breathing companies. These companies, taken collectively, do everything under the sun for which people will pay money.  Some stocks represent banks and other financial companies. Some stocks represent restaurants. Some represent clothing stores. Some represent mining, and some represent drilling for oil. When investment experts talk about sectors, they are talking about groups of stocks that have underlying businesses engaged in the same sort of income generating activities.

Because these companies do the same basic thing, they are subject to similar economic forces.   Sectors tend to rise together when economic conditions are good for those types of companies and fall together when economic conditions are bad.  For the investor, this means that poor sector performance can mean poor portfolio performance if you are not diversified across not only different stocks but different sectors of stocks.  Take the financial sector for example. If interest rates are on the rise and all of your investments are in bank stocks, then your whole portfolio will likely rise. If interest rates are cut, then your whole portfolio stands to plummet.  For the individual investor, the best advice is probably to buy the best of breed stocks across as many different sectors as you can.

In the United States, the most common system that you will see for sector classifications is the one used by Nasdaq.   Nasdaq uses the ICB (Industry Classification Benchmark) which is maintained by the FTSE Group. This system uses a hierarchical approach in which there are ten “industries” at the topmost level, 19 “supersectors” below that, and 41 “sectors” below that, and the fourth level with 114 “subsectors.” (You can download an Excel spreadsheet of this information from  http://www.icbenchmark.com/structure)  Be aware that these sector classifications may change depending on which information service you use.  When I look up the symbol TST on TD Ameritrade, it tells me that it is classified as “Financials: Capital Markets.”  When I look it up on Yahoo! Finance, I find that it is classified as being in the “Internet Information Providers” industry and in the “Technology” Sector.

There are several indices and ETF (Exchange Traded Funds) that are sector based, allowing you to invest across a wide swath of stocks in a particular sector.  The sector ETFs are like broader index funds that only provide exposure to one sector rather than the entire market. Understanding a particular sector is important when picking stocks.  Different businesses measure success in different ways, and if you don’t know how to tell if a particular breed of business is successful, you obviously shouldn’t speculate in that sector’s stocks.  

A great way to find information about investing in a particular sector is to read the research done by high-quality research and investment firms, and of course by following the sector on TheStreet. Always remember that the fortunes of individual stocks are tied to sector evaluations, largely because of these behemoth sector funds.  Perfectly solid companies with a stellar trajectory can take a huge hit if investors (especially the big institutional ones) dump the entire sector, just as they can when there is an overall market decline like the Great Recession. If you have done your homework, evaluated the fundamentals, and have conviction about the company’s story, then sector selloffs present an important buying opportunity.

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