Understanding the movement of the stock market as a whole helps investors commit to their investing strategy and to manage their portfolios like a professional, but well diversified investors may find that understanding total stock market movements do not contextualize the movements well enough to make investing decisions that fit with their strategy. Because of this, many DIY investors (particularly those who choose individual stocks as a part of their investment strategy) need to engage in sector analysis to evaluate the equity portion of their portfolio, and DIY.Fund now has the tools that investors need to engage in this type of analysis.
Sector analysis allows portfolio holders to compare stocks within a given industry to the group as a whole.
Stock market sectors are groupings of publicly traded companies that share common market characteristics. Every publicly traded company falls into one of eleven major sectors which include:
- Basic Materials
- Communication Services
- Consumer Defensive (Companies that provide consumer goods that consumers will purchase even during recessions)
- Consumer Cyclical (Companies that provide consumer goods that consumers will purchase more during boom times and less during downturns).
- Financial Services
- Real Estate
Categorizing stocks into sectors makes it easier for investors understand the common market characteristics that drive a sector’s performance, and to determine the place a sector should hold in an investor’s portfolio.
Just as the stock market as a whole has a benchmark (The S&P 500), each sector of the economy has a sector specific benchmark. At DIY.FUND, we use the sector select SPDR ETFs as a sector benchmark. Sector select SPDR ETFs break each of the 500 companies in the S&P 500 into one of the eleven major investment sectors, and the performance of the ETF represents the benchmark for the sector.
Why should investors understand sector investing?
A sector specific benchmark allows investors to contextualize their portfolio’s under and over performance, and to determine whether or not their exposure to certain sectors fit within their investing goals.
The stock market as a whole tends to go through “Business Cycles” or periods of expansion followed by periods of slow growth and contraction. However, not every sector follows the same cycle as the economy as a whole.
Some sectors, like utilities and consumer defensive are far less volatile than the economy. They don’t grow as quickly during expansions, but they rarely fall as far during contractions. On the other hand, some sectors amplify the business cycle. Showing higher growth during expansions and further drops during contractions.
Likewise, investors need to understand their exposure to certain sectors to review whether their sector allocation fits with their long term investing goals.
Using sector analysis to make investing decisions
Sector analysis is not only useful for understanding portfolio performance, it can also help investors make better investing decisions.
For example, understanding your allocation to a sector, and how a sector performs relative to the S&P 500, will allow you to decide if you are over or under exposed to a given sector. If an investor finds that she is underexposed to a certain sector, she may choose to rebalance her portfolio by buying more stocks or funds in a given sector.
An investor may also choose to invest more heavily in a sector that appears to be underperforming the market since it could indicate that it is part of a predictable downswing. Since no two business cycles follow the same pattern, investors should be aware that understanding sector performance will not always yield profitable outsized profits.That said, a cohesive view of sector and market performance will prevent DIY investors from making costly errors like overinvesting during a sector’s peak price or selling when a certain sector is down.