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 can be used:
- 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 Facebook have very different approaches to connecting users with headlines, but they share the same target market of internet users.
The 3 methods of 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 systems to organize industries: the Global Industry Classification Standard (GICS), the Industrial Classification Benchmark (ICB), and the Thomson Reuters Business Classification (TRBC).
1. Global Industry Classification Standard (GICS)
The Global Industry Classification Standard (GICS) is a market-based classification system with over 58,000 companies across 125 countries, segmented into 11 sectors based on the company's "primary business activity." Within each sector are industry groups (24 in total), industries (69), and sub-industries (158). 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||Communication services||Utilities|
2. Industrial Classification Benchmark (IBC)
The Industrial Classification Benchmark (ICB) classifies more than 100,000 companies, in more than 72 countries, into 11 industries based on the company's "source of revenue." Within each industry there are supersectors (20 in total), sectors (45), and subsectors (173). The first tier of the ICB structure divides the market into the following 11 industries:
|Consumer discretionary||Consumer staples||Industrials||Basic materials||Energy||Utilities|
3. Thomson Reuters Business Classification (TRBC)
Thomson Reuters Business Classification (TRBC) includes over 250,000 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 (54), 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|
You're not losing your mind, or your eyesight—these 3 classification methods 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.
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 methodology 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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