Investors who engage in sector investing usually do so in one of two ways. Either they buy mutual funds or ETFs that concentrate on a certain sector or they pick stocks in a favored sector as a way of concentrating on an area thy believe is going to do well.
In terms of risk, buying stock in a single company is the riskiest. Buying a broad index mutual fund or ETF without regard to sector is the least risky option. Sector investing falls somewhere in between, depending on whether you are buying individual stocks in a sector or a sector index fund.
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Why Investors Do It
You may believe a certain sector, say technology, is set to take off or has done well in the recent past with no sign of slacking off. At the same time, you may be unsure about which companies within a sector are going to be the most profitable. This is why people get involved in sector investing.
Sector investing, as opposed to investing in only one company in a sector, eliminates the decision about which stock you should invest in.
A sector is an industry or market that shares certain common characteristics. Sector categories include technology, health care, energy, utilities, telecommunications and others. Based on history and current events, each sector has a different risk profile.
While there are many ways to define sectors, the Dow Jones U.S. Total Stock Market has 10 sectors: Basic Materials, Consumer Goods, Consumer Services, Financials, Health Care, Industrials, Oil & Gas, Technology, Telecommunications and Utilities.
When it comes to picking a sector in which to invest, it makes sense to know something about the state of the economic cycle and which sectors tend to do well in each part of the cycle. The economic cycle has 5 stages – Early expansion; Middle expansion; Late expansion; Early contraction; Late contraction.
Looking at market data over a long period, certain sectors tend to perform better than others, depending on the stage they are in. Early expansion, for example, favors consumer goods, transportation and technology. Middle expansion is kind to capital goods. Energy, basic materials and consumer staples do well in late expansion. Early contraction favors utilities and consumer staples. Finally, consumer cyclicals and financials do well in late contraction.
How To Tell Which Stage We Are In
It’s far from easy to know which stage of the economic cycle we are in until it’s over. That’s a given. Some investors start by identifying sectors that are performing well. If your list matches one of the cycles mentioned above, it’s a good bet the economy is in that cycle.
Use technical analysis to look at “leaders” and “laggards” in the market. Search for companies that are thriving. Use them to build your list. Also use indicators such as inflation and interest rates. In periods of growth, inflation and interest rates tend to stay low while industrial output increases. Low inflation and interest rates are what allow growth to take place. When this happens in a sector, that is the best time to invest in that sector.