Managing Your Investment Portfolio: Part Eight
Sectors & Industries
by Gerald Townsend, Financial Editor
August 2010
We are now in the 8th installment in our series on "Managing Your Investment Portfolio." Previous articles examined setting goals, risk tolerance, asset allocation and geographic considerations. This month focuses on economic sectors and industries.
An economic sector is a broad categorization method of grouping companies, such as "financial" or "utilities." A sector is a unique economic entity that responds differently from other sectors to the ebb and flow of the business cycle, government regulations, technological changes, etc. An "industry" is a way of further refining a sector. For example, within the financial sector you have industries, such as banks, insurance companies and brokerage firms.
Using the MSCI/S&P Global Industry Classification Standard (GICS), the economy is divided into ten sectors, as shown in the accompanying table (below). Note that this table is based on the S&P 500 index. If other indexes were used, the allocations would obviously be different, but the S&P 500 is considered a good proxy for the U.S. market. This table shows how the S&P 500 index is allocated among sectors as of the end of the year — for various prior periods and the current allocation. The sector weightings in this index use the values (market capitalization) of the component companies. Therefore, the increase of the Consumer Staples sector from 9.6% in 2005 to 11.6% today, means that stock prices of companies in that sector rose, while those of companies in the Consumer Discretionary declined during the same period, since that sector fell from 10.7% to 10.1%.
Most of these sector names are self-explanatory, but let’s clarify a few of them. A "Consumer Discretionary" company is one that is also considered a "cyclical," meaning its fortunes tend to ride and fall with the business cycle (e.g. Whirlpool), as contrasted with a "Consumer Staples" company (e.g. Proctor & Gamble), whose products are more recession-proof. Examples of other sectors are Boeing (Industrials); Dow Chemical (Basic Materials); and AT&T (Telecommunications).
A diversified stock mutual fund allocates its money among these sectors, and a person constructing their own individual stock portfolio should be doing the same — for both risk and return reasons. Each sector responds somewhat differently to each stage of a business cycle, so having investments diversified across multiple sectors is a form of risk control. The return difference between the best and worst sector averages about 50% a year, so a portfolio too heavily weighted to a particular sector could result in a home run — or a strike out.
If you are a passive investor and own an S&P 500 index fund, your allocation should exactly match the index — after all, that is its goal. However, if you are an active investor, use the market allocation as a guide or as a checkup on your portfolio, but don’t slavishly adhere to today’s allocation. There are a number of reasons for this:
- First, you will note from the table below that sector allocations change over time. Economies, and the companies within them, are living organisms — so today’s allocation will not be tomorrows.
- Second, a company’s business focus and sector may change. In addition, there are a number of companies operating in multiple sectors, and this classification method necessarily assigns them to just one particular sector.
- Third, sometimes a sector may get ahead of itself and be ripe for a correction. Note the technology sector weightings at the end of 1995 (9.4%); 2000 (21.2%); and its current weighting (16.3%). The technology sector actually comprised 33% of the S&P at the beginning of 2000, just in time for the bust of that sector. You see a similar boom-bust pattern with the more recent collapse of financial stocks. Therefore, strictly following a current sector allocation may lead you into over-heated areas that are on the verge of cooling off.
Gerald A. Townsend, CPA/PFS, CFP®, CFA® is president of Townsend Asset Managment Corp., a registered investment advisory firm. Email: Gerald@AssetMgr.com