Do you remember the Kingdom, Phylum, Order distinctions from your high school biology class? Refresher: these are the ‘taxonomic ranks’ of the biological world, they’re how we break down biology to understand it better. Kingdom Animalia, Phylum Chordata, and Class Mammalia? The red fox!
Economy, Sector, and Industry are sort of like that. These terms are ways to break down the economy into pieces that investors can then analyze and understand.
When it comes to investing and the stock market, a sector refers to a large segment of the economy. Companies within a single sector have a common product or service.
There are 11 different sectors reflected in the U.S. Stock Market:
- Communications services
- Consumer Discretionary
- Consumer Staples
- Health Care
- Real Estate
Each sector then contains several industries. An industry is a narrower distinction that represents a specific group of companies. For instance, the materials sector can contain the chemicals and construction materials industries.
By way of example, Johnson & Johnson is part of the health care sector and the pharmaceutical industry, and Chevron is part of the energy sector and the oil & gas industry. One company can also have its feet in multiple sectors and industries.
General Electric, for example, is one company, but it’s in both the energy and industrials sectors.
An entire economy can be broken down into sectors, which, when combined, account for pretty much all the activity of the economy. Certain economies are even known for particularly successful sectors; think Saudi Arabia and energy, China and industrials, and the United States and technology—Apple, Microsoft, and Google ring any bells?
Often people choose to invest in particular sectors and industries in order to diversify their portfolios.
Often people choose to invest in particular sectors and industries in order to diversify their portfolios. Diversification is an investing technique that involves investing across varying sectors, geographies, and asset classes in order to weather the ups and downs of particular investments. Different sectors potentially behave differently in different economic environments.
This can be well illustrated by two sectors that sound similar, but are often behave individually: consumer staples and consumer discretionary. Consumer staples are the things you really need to survive, think food and beverages, household goods, and personal products. The consumer discretionary sector includes industries like retail, hotels and leisure, and clothing and apparel. During hard economic times, the consumer staples sector tends to thrive, as people continue to buy the things they need while cutting back on more discretionary purchases. During economic boom times, the consumer discretionary sector tends to benefit as people spend their extra income on travel, restaurants, and more leisure-oriented purchases.
Mutual funds and exchange-traded funds, or ETFs, often attempt to track indexes, which are groups of companies with something in common. While some indexes, such as the Dow Jones Industrial Average are broad, others track entire sectors.
With that in mind, well-known exchanges like Nasdaq and the New York Stock Exchange (NYSE) have sector-specific indexes, such as the NASDAQ Telecommunications Index and the NYSE Health Care Index.
Fun Fact: the Dow Jones Industrials Average doesn’t only track industrials, though it used to! It was first calculated in the 1800s and made to represent the industrial sector. Now it tracks some of the largest companies in the United States like 3M, ExxonMobil, and Verizon.
As an investor, it can be important to be broadly diversified across sectors and industries. Putting all your money into one sector means that you will benefit when it is doing well, but you will feel the pangs of loss when that sector has a setback. Though even the most diversified portfolio can suffer losses as all investing involve risk, broad diversification across sectors and geographies can help to guard against loss when a particular sector suffers.