The Pros and Cons of Sector Investing

by Nancy Zambell

Generally speaking, 2018 was a bad year for investors. The S&P 500 was down more than 6%, while the Nasdaq tumbled nearly 4%. But not every sector tanked. And therein lies the advantage of sector investing.

To wit: if you invested in healthcare stocks (+6.5% in 2018) or utility stocks (+4.1%) last year, you probably did OK. However, if you bought energy stocks (-18.1%), materials stocks (-14.7%) or industrials (-13.3%), you probably had some pretty big losers. So, it’s important to be in tune with what stock market sectors are outperforming and which are trending downward. But sector investing isn’t quite as simple as that.

So let’s dig a little deeper.

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Sector Investing Advantages and Disadvantages

Some investors like to trade stocks, based on their predictions for the economy, certain industries, or the market as a whole. Those focused on buying stocks in ‘bullish’ sectors or industries will pay attention to the current economic cycles.

As you can see from the chart below, during certain market cycles, some sectors do better than others.

Before sector investing, ask yourself where we are on this chart currently.Fortunately, for investors trying to capture the biggest gains during the bullish periods, they have hundreds of sector mutual funds or exchange-traded funds (ETFs) from which to choose.

The list of available sector funds usually includes technology, financial, consumer cyclical, consumer staples, utilities, energy, natural resources, healthcare, real estate, and precious metals. But, note that each of these can be subdivided into even smaller sectors.

There is voluminous data on successful sector strategies, such as the huge gains from technology investing in the late 1990s and real estate investing in the early-to-mid-2000s. But we all know what happened to those sectors when technology went bust, and when the most recent recession hit. That’s the risk in sector investing. When the decline happens, it usually occurs quickly and is accompanied by significant drops.

You only need to look at the sector’s beta (volatility, as compared to the S&P 500) to ascertain the predicted volatility of the sector. Last September, several important changes were made to the Global Industry Classification Standard (GICS®), changing the forecasted beta of several sectors as shown in the graph below.

Beta: a measure of volatility relative to the broader market, as represented by the S&P 500, which has a beta of 1. A sector with a beta of 1 has historically exhibited the same level of volatility as the market. A sector with a beta less than 1 has historically exhibited less sensitivity to market moves, while a sector with a beta greater than 1 has exhibited more sensitivity to market moves. Betas shown are for the 36-month period ending June 2018. (Source: Standard & Poor’s, FactSet, as of June 30, 2018.)

The advantage to sector investing is diversification using a professional manager when you are not well-versed on a particular industry, as well as the potential for substantial gains when that sector excels. But the downside is significant risk, should you be on the wrong side of the bet.

For prudent investors, you might consider adding sector investing to your portfolio, but keep the allocation to maybe 5% of your holdings for each sector. You can also diversify by employing certain sectors for longer-term investing (those that are least volatile) and others for your short-term, more speculative funds.

Nancy Zambell

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Nancy Zambell, Editor of Wall Street’s Best Investments, has spent 30 years helping investors navigate the minefields of the financial industry. Nancy scours more than 200 advisories and research reports to select the top recommendations, which she collects for you in this easy-to-read digest.

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