What it means
Markets contain thousands of companies, so analysts sort them into groups. A sector is the broadest grouping, and each sector is then divided into smaller industries and sub-industries.
For example, a bank and an insurer both belong to the financial sector but are different industries within it. Several classification systems exist.
The widely used Global Industry Classification Standard (GICS) divides the stock market into eleven sectors, including information technology, health care, financials, energy, utilities and consumer staples. Other index providers have their own systems, so the exact lists vary slightly.
Sectors matter because companies within one tend to move together. A rise in oil prices affects most energy companies, while a change in interest rates affects banks and real estate in similar ways.
Investors use this to understand why a share has moved and to check whether a company is doing better or worse than its peers. Sectors also differ in character.
Defensive sectors, such as utilities and consumer staples, tend to hold up better in downturns because people still need power and food. Cyclical sectors, such as industrials and consumer discretionary, tend to follow the economy and rise and fall more sharply.
For portfolio building, sector weights show how concentrated an investment is. A portfolio heavily in one sector can suffer if that sector falls out of favour, even if it holds many different companies.
Managers often compare their sector weights with a benchmark index to see where they are taking extra risk. Sector labels are also useful in everyday business conversations.
When a manager says a company is in the retail sector, listeners instantly know which competitors, customers and risks to think about. It saves time and gives a shared starting point for discussions about performance.
In practice
Real-world examples.
Example
A fund manager notices that 45% of her portfolio is in technology while the benchmark index has 30%. She is overweight the sector by 15 percentage points. She decides whether the extra risk is intentional or needs reducing, and records the reason in her investment notes so that the decision can be reviewed later.
Example
A finance director at a food manufacturer compares the company's margins with other firms in the consumer staples sector. Her gross margin of 28% is below the sector average of 33%. She starts a review of supplier costs and packaging prices to find where the gap comes from.
Example
A retail investor owns shares in five companies, all of which are energy producers. When oil prices fall sharply, all five drop together. She realises that owning many companies in one sector gave less protection than she expected, and she begins adding holdings from other sectors.
Formula
Calculation
Sector weight = value of holdings in the sector / total portfolio value x 100
An investor holds a $500,000 portfolio with $150,000 in technology shares, $100,000 in health care, $125,000 in financials and $125,000 in energy. The technology weight is $150,000 / $500,000 = 0.30, which is 30%. Health care is $100,000 / $500,000 = 20%, and financials and energy are each $125,000 / $500,000 = 25%. The four weights add up to 100%.Case study
Seen in the real world.
Lakeshore Pension Trust is a fictional scheme with $80,000,000 in equities. A review by its investment committee found that 38% of the shares were in the financial sector, because the trustees had added banks and insurers over several years.
When a banking scare caused financial shares to drop, the trust's portfolio fell more than the wider market. This is an illustrative story, but it makes a practical point. The committee set a rule that no single sector could exceed 25% of equities, and rebalanced into health care, utilities and industrials to spread the risk.
Over the following year the committee reported sector weights at each quarterly meeting alongside the benchmark. It also asked its fund managers to explain any holding that took the trust more than 5 percentage points away from the benchmark in a sector.
Watch out
Common mistakes.
- Assuming a diversified list of companies means a diversified portfolio. If the companies are in the same sector, they may all fall for the same reason.
- Treating sector and industry as the same thing. A sector is the broad group, and industries are smaller parts within it.
- Comparing a company with the wrong peers. A fair comparison needs companies in the same sector, and ideally the same industry.
Questions
People also ask.
How many sectors are there?
It depends on the classification system, but the widely used GICS framework divides the stock market into eleven sectors.
What is a defensive sector?
It is a sector, such as utilities or consumer staples, whose demand stays fairly steady in downturns.
Why do analysts compare companies within a sector?
Companies in the same sector face similar conditions, so comparisons of margins, growth and valuation are more meaningful. A comparison between a bank and a software firm, for example, would tell you very little.
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