Sector investing may sound like it’s for the pros. But even if you're an average investor just starting out in the market or steadily working toward goals like retirement, you might want to consider this strategy to help align your investments in support of your specific long-term investing objectives.
Think of sector investing as a way to take economic cycles into account. Like the weather, economic conditions have their seasons, and just as it’s best to dress properly for the time of year, it can make sense to examine sectors based on current economic conditions. This doesn’t necessarily mean jumping in and out of stocks and sectors all the time; but it can mean trimming or adding to positions in certain sectors at specific times, even while maintaining a diversified portfolio.
And for long-term investors with many years until retirement, it could also mean keeping more money in some of the sectors that provide exposure to equities with higher growth and corresponding higher risk. That means sectors like info tech, consumer discretionary, and industrials—all of which tend to have their ups and downs, but often provide more long-term growth potential to help long-term investors meet specific goals like retirement. Keep in mind that these "growth stocks" have a connotation of higher risk for a reason, and as investors approach retirement, the role of higher risk stocks becomes more questionable and the risks become harder to justify.
“For millennials, the goal of sector investing is to outperform the broader market,” said David Settle, Curriculum Development Manager at Investools, a TD Ameritrade education affiliate. Other investors, too, might want to consider being less conservative with some of their funds and use sector investing if they are striving to grow their money more quickly."
Why Use Sector Investing?
Economists often say that a typical market economy cycle has four phases: Expansion, peak, recession, and recovery. The stock market tends to reflect where the economy is in those phases, and certain sectors tend to perform better during certain phases. Here’s the standard sector cycle:
Expansion: When the economy is in the expansion phase, Settle said, economic growth expectations are rising. During this part of the cycle, technology and consumer discretionary have often tended to outperform other sectors because these are the parts of the economy that help fuel economic expansion.
Peak: When the economy reaches a peak, and interest rates usually start rising (as seems to be the case now), the financial sector often outperforms because bank stocks tend to benefit from rising rates. Additionally, energy and materials can outperform because the economy tends to generate a lot of growth at these times.
Recession: When a recession hits and stock prices fall, that’s often when sector investors consider defensive parts of the market, including utilities, consumer staples and healthcare, in part because companies in these sectors tend to see steady demand for their products and services even if the economy is in a down turn.
Recovery: And as the economy recovers, investors might want to look at the sectors typically associated with the recovery phase. These can include industrials and materials.
The caveat is that when the market is in a certain part of the cycle, sector-based investors will likely be looking ahead to what sector generally performs best in the next part of the cycle, because the market might get there soon and they might consider those sectors to be a better choice. Of course, guessing when the economy moves from one stage to the next is just that, a guess. Several months of GDP numbers are typically needed in order to see if economic conditions have changed.
“Those striving to benefit from cycle changes need to start preparing for the next phase of the cycle when they recognize the phase we’re in, because it’s so hard to time when these phases begin and end, especially for the retail investor,” Settle said.
Owning Sectors for the Long Term
Having a sector strategy as part of a larger, diversified portfolio isn’t about timing the economic cycle. Instead of rotating in and out of sectors with changes in economic conditions, it's about being in specific sectors intended for an investor’s particular age group.
Investors with a longer time horizon—millennials up through middle-aged folks—may want to consider the advantages of traditionally high-growth sectors like info tech, consumer discretionary, and industrials. The theory here is that younger investors have the time needed to ride out the risks of growth stocks. Over the last five years, the three leading growth sectors are health care (up 78%) , consumer discretionary (up 74%), and info tech (up 64%), according to research from TD Ameritrade. Health care is usually thought of as a defensive sector, but strong growth in the health care sub-sector of biotech has helped contribute to health care’s strong performance.
However, consumer discretionary and info tech fit nearly into the growth sector category, and other growth sectors like financials and industrials are also up sharply over the last five years. Though these sectors can sometimes deliver a choppy ride, and often fall more during recessions than defensive sectors, they may potentially provide large growth over the long term. That means more possibility to meet goals like retiring at a certain age or paying off a mortgage as well as a greater risk of getting caught in an economic downturn just as you are about to retire.
Though the last 10 years shows things aren’t always predictable, younger and middle-aged investors might want to consider keeping more of their funds in growth sectors if they’re going to meet the goals of putting enough aside for retirement, buying a home, and eventually raising children and sending them to college. Info tech and consumer discretionary sectors are past examples some say were able to deliver the type of growth—over long time periods—that can potentially help investors meet those goals. Of course, the risks along the way are not for everyone, and as investors approach their goals they may experience a change in risk attitudes.
Growth doesn’t just come from stocks going up. Certain sectors, including utilities, telecommunications, and consumer staples, often provide dividends to investors, along with the opportunity to reinvest the dividends to purchase additional shares of stock. Some companies who don’t traditionally pay dividends, most notably info tech, have started doing so recently.
Long-term investors could potentially benefit by keeping dividends in mind as part of a sector strategy. Those dividends often pay off by giving investors additional exposure to future stock gains through dividend reinvestment, and helping to build long-term wealth. Those wishing to stay in stocks but dial risks down a bit, like investors nearing retirement, may examine sectors known for dividends.
Potential Disadvantages of Sector Investing
Adjusting one’s portfolio to reflect the economic cycle isn’t always easy, and takes a bit more effort than just buying and holding stocks for the long term. And, as we’ve seen, there’s some risk involved, perhaps more than there would be in a straight buy-and-hold type of strategy. The stock market reflects human psychology, which isn’t always linear or mathematical, and that means sector investing can throw the occasional curveball.
For instance, 10 years ago, investors who followed the sector strategy had no way of knowing that financial stocks—a traditional source of growth—would fall 14% over the next 10 years. To be fair, that performance mainly reflects the wear and tear caused by the Great Recession of 2007-2009, and financials are up 110% over the last five years. But nonetheless, it's a reminder that the market generally moves as a random walk rather than a straight line.
Do Your Research
We offer a variety of sector-specific research resources designed to help investors understand and implement sector investing strategies. Learn where to start with sector investing by learning about tools such as top-down analysis, Market Monitor, and analyst reports that can help you find investment ideas that align with your specific investing objectives.
The Sectors & Industries tool is one way to perform top-down analysis. This tool (see figure 1) is based on the S&P 500 and its 11 sectors: Consumer Discretionary, Consumer Staples, Energy, Financials, Health Care, Industrials, Information Technology, Materials, Telecommunication Services, Real Estate, and Utilities. To access the tool, log in to your account at tdameritrade.com and go to Research & Ideas > Markets > Sectors & Industries.
The investing journey is a long one for younger and middle-aged market participants, and it’s often tempting to play it safe. In sector investing, the idea is that those with time on their side can ride out the storm. But being too conservative also has risks, and sometimes a little risk taking, including sector-based investing, can help accelerate growth if properly executed. Of course, as investors approach and reach retirement, the risks looks less theoretical, and become starkly real. As always, it’s important not to count on any one strategy on its own, and to maintain a diversified portfolio as a safeguard against possible over-exposure to any one sector.
Sift through Sector Candidates
Use Stock Screener to narrow selections based on sectors like technology. Log in to your account at tdameritrade.com > Research & Ideas > Screeners > Stocks.