Markets
With more than 3,500 publicly-traded companies in Canada alone, understanding all of the nuances, risks and opportunities of the market can be challenging even for the most sophisticated investor. One way to make the market more approachable and understandable is to break it down into smaller, more manageable parts through a process called sector analysis. By classifying companies that make up the stock market into sectors based on similar business activities, investors can gain a deeper understanding of the market and its various components.
This article will introduce market sectors, shedding light on how companies in different sectors can react differently to economic shifts and market fluctuations. Having an awareness of these nuances offers insights for investors on how to manage their portfolio’s risk and express their investment preferences, empowering them to make more informed decisions towards achieving their investment goals.
What are market sectors?
Just as a cookbook categorizes recipes into sections like salads, soups, and entrees to help plan a well-rounded meal, the Global Industry Classification system (GICS) classifies companies into sectors to help investors find similar companies quickly and easily. Each section in a cookbook contains recipes with similar ingredients and techniques, while each sector contains companies with similar business activities and functions. This categorization allows one to select a variety of dishes that meet their dietary needs and preferences, and similarly, the GICS enables investors to choose a mix of stocks that align with their financial goals and risk tolerance.
The GICS, created by MSCI and S&P Dow Jones Indices, is the most widely used system for classifying companies. This standardized system categorizes companies into 11 broad sectors, which are further subdivided into 25 industry groups, 74 industries, and 163 sub-industries. GICS provides a consistent framework for analyzing and comparing companies across global markets.
The 11 broad stock market sectors
Investment considerations
As one can see in the chart above, companies will have revenue sources, business models and risks that vary widely across sectors. As a result, companies in different sectors often respond differently to economic changes because they have varying sensitivities to a variety of factors like interest rates, consumer spending habits, and input costs. For example, an online furniture retailer will be much more sensitive to changes in consumer behaviour than a uranium mining company that would be more heavily influenced by global commodity prices and the global supply and demand of energy. Conversely, companies in the same sector tend to be affected by similar factors, whether it be in a positive or negative way.
The business cycle—which is the natural fluctuation of the economy between periods of growth and decline—impacts all companies, but not always in the same ways or to the same extent. Because each sector is unique in its sensitivities to changing economic conditions, there are phases of the business cycle in which certain sectors tend to outperform others. Creating a well-diversified portfolio means, in part, to hold a variety of investment types with characteristics that will perform differently under the prevailing market conditions. By having exposure to a variety of sectors, the negative performance of one can be buffered by the relative positive performance of another, providing greater stability to overall portfolio returns across the entire business cycle.
More experienced and risk tolerant investors may attempt to surmise what phase the business cycle is in and over or underweight sectors in their portfolio based on their analysis. This active approach, known as sector rotation, comes with greater risk and potential to underperform should the investor’s views fail to materialize. Additionally, certain investors may hold beliefs that certain sectors are poised to outperform or underperform for other reasons and want their portfolios to reflect their outlooks.
Final thoughts
Navigating the stock market doesn’t have to be overwhelming. By understanding what sectors are, investors gain increased awareness and clarity on the investments that make up their portfolio. Knowing the sector exposure within their portfolio can help an investor to discern if they are properly diversified or if their portfolio reflects their market outlook. This allows an investor to be able to better manage their investments according to their needs, preferences and appetite for risk.
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