What you should know about sectors and industries

Diversification isn't as simple as having a mix of stocks and bonds in your portfolio.

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You already know you should diversify—the question is how. While you divide your portfolio among various assets, from stocks, to bonds, to alternative investments, you can further diversify within each asset class.

Using sector-based securities or funds allows you to diversify the stock part of your portfolio among various industries. It's like walking into an ice cream shop and choosing a combo of flavors that all happen to be ice cream.

Here's how industry sectors are organized so that you can steer your stock funds in the right direction.

2 approaches to sectors

Let's look at Pepsi and Under Armour. Pepsi appears to be a food and beverage company, while Under Armour is considered consumer goods. But sorting all stocks into different sectors requires a more focused look because different criteria may be used. Two different classification systems tend to be employed:

  • A "production-oriented approach" focuses on the products a company makes and its manufacturing process. With the "Consumer Goods" sector, for example, luxury designer Michael Kors and yoga pants retailer Lululemon make clothes for very different purposes and clients, but their process is the same.
  • A "market-oriented approach" focuses on the markets the company serves instead of the products they make. For the "Information Technology" sector, for example, Twitter and Yahoo have very different approaches to connecting users with headlines, but they share the same target market of internet users.

The 3 schemas classifying industries within each sector

Just like memorizing taxonomy naming conventions in your high school bio class to separate the animal and plant kingdoms, investors use 3 main "classification schemas" to organize industries: the Global Industry Classification Standard (GICS); the Industrial Classification Benchmark (ICB); and the Thomson Reuters Business Classification (TRBC).

Schema #1: GICS
The Global Industry Classification Standard (GICS) is a market-based classification system with over 43,000 companies worldwide as of 2014, segmented into 11 sectors based on the company's "primary business activity." Within each "sector" are industry groups (24 in total), industries (68), and sub-industries (157). The first tier of the GICS structure divides the market into the following 11 sectors:

Energy Materials Industrials Consumer Discretionary Consumer Staples
Healthcare Financials Information Technology Real Estate Telecommunications Utilities
*Source: S&P/MSCI

Schema #2: ICB
The Industrial Classification Benchmark (ICB) classifies more than 70,000 companies, in more than 70 countries, into 10 industries based on the company's "source of revenue." Within each "industry" there are supersectors (19 in total), sectors (41), and subsectors (114). The first tier of the ICB structure divides the market into the following 10 industries:

Oil & Gas Basic Materials Industrials Consumer Goods Healthcare
Consumer Services Telecommunications Utilities Financials Technology
*Source: FTSE

Schema #3: TRBC
Thomson Reuters Business Classification (TRBC) was developed in 2004 and includes over 70,000 companies from 130 countries, segmented into 10 economic sectors according to the company's "primary business activity that provides the largest revenue contribution." Within each economic sector, are business sectors (28 in total), industry groups (56), industries (136), and activities (837). The first tier of the TRBC structure divides the market into the following 10 economic sectors:

Basic Materials Cyclical Consumer Energy Financials Healthcare
Consumer Services Non-cyclical Consumer Technology Telecommunications Utilities
*Source: Thomson Reuters

Slight differences

You're not losing your mind, or your eyesight—these three schema are very similar. Although the differences between each classification are small, the distinctions determine which companies fall into each sector, and the result has a large influence on industry benchmarks. For instance, check out airline companies: GICS classifies them as part of its "Transportation" subsector; TRBC splits up airline companies further into those providing transportation for consumers and those providing airport services; and ICB simply throws all airlines into the "Travel and Leisure" supersector, along with bars and restaurants.

Conclusion

Diversification isn't as simple as having a mix of stocks and bonds in your portfolio. In addition to diversifying within each asset class, make sure you know the schema of sector breakdowns to ensure you're properly investing in the right mix of industries for your portfolio and comparing them to the proper benchmarks.

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