The term “sectors” is often thrown around, but what exactly does it mean and why should you care?

In short, the economy and financial markets can be broken down into segments called sectors, which are simply large groupings of industries in similar businesses. Each sector can be further broken down into industry groups. For example, the financial sector includes banks, asset managers, life insurance, brokers, etc. Because certain fundamental factors tend to affect financial stocks in a similar fashion, it’s often helpful to look at not only the market as a whole, or just at individual stocks, but at levels that are in-between. Think of this like looking at the market from different distances.

Imagine looking at a basketball-sized globe from five feet away. That’s like looking at the world markets. Step a foot closer and you can see the U.S., which is like looking at the S&P 500, for example. Step another foot closer and you can see the individual states — which are like the sectors in the economy. Another foot closer still and you can see the industry groups — which are like major metropolitan areas and regions within a state, like the Dallas-Fort Worth Metroplex. And finally, another foot closer and you can see smaller cities — which are like the stocks within a sector.  

Why is this important? There are a few reasons.

1. Opportunity is not always found at the same level. Sometimes the entire market looks pretty good. Other times certain sectors may look great, but others look poor. I refer to this as sector disagreement. In other words, for the overall market to trend up, it needs a lot of sectors to agree to go up. If they don’t agree, some sectors may still go up, but the poor sectors may drag down the overall market.

2. Research time is precious and expensive. It is absolutely impossible for anyone to know every stock in the universe and be able to weigh its viability as an investment against every other stock. Even attempting to do so is foolish. One of the most important decisions you can make is knowing where to spend your research time.

3. If you think of stocks as houses and sectors as neighborhoods, accept that safe houses are usually found within safe neighborhoods. Trying to go into a bad neighborhood and pick which house isn’t going to get broken into is not investing — it’s speculation. This also ties into number two regarding research time. Even if you were going to try to pick that one good house in a bad neighborhood, and they do exist, you would have to do a tremendous amount of research on a lot of different houses to come to your conclusion. And even if you did pick the best of the worst, that doesn’t necessarily translate into long-term profit, let alone meeting your life goals, which is the reason you are investing in the first place.
   
   People often ask me what I think about a particular stock. Fact is, I don’t think at all about a lot of stocks — some have earned research time and some have been filtered out. If a stock doesn’t pass our filters to earn research time, I don’t think about it; this is one manifestation of investment discipline. If it’s in a bad neighborhood, it’s a speculation, not an investment. I’m an investment advisor, not a speculation advisor. I simply don’t go pilfering through my trash to find individual stocks with which to build emotional relationships. Every fund, sector or stock we follow is a business decision. Now, I’m not saying there is no place for speculation; I’m just saying it’s very important to call it what it is and not consider these speculative gambles with money set aside for investing.

4. Starting your analysis from the individual stock level puts you at an extreme risk of making emotional decisions, and is a huge waste of time. If you want to own a particular stock, you’ll look for information that confirms your opinion and be biased toward it, as it supports your emotions. In psychology, this is referred to as confirmation bias, and it’s happening whether you are aware of it or not. Also, starting at the stock level keeps you from seeing a specific opportunity in the context of other opportunities — you could miss great by focusing on good.

There are tons of ways to study the sectors and how they interact, and this is only the tip of the iceberg. There is a lot behind-the-scenes activity in investment management, but I hope you enjoyed this short peek into one thing we think about when building portfolios and rebalancing them to meet your personal goals.