How I plan to Optimize Sector Allocation – Part 2

In the first part of this series, Inspired by Geoff over here, I had a look at how my portfolio was performing against a benchmark using performance attribution.

I learned that the strategy I currently have in place where I use certain metrics to chose 5 companies a month to watch may not be the most efficient strategy. It was a good starting point but I really want my money working harder than I do. Therefore it is in my best interest to constantly learn and improve my strategy.

My Monthly reports show that over time the cash I am receiving from my companies is increasing. Watching the dollar amount increasing over time, masked the fact that my portfolio has its flaws.

“There are no facts, only interpretations.”

― Friedrich Nietzsche

My allocation weighting returned a rather poor -0.87% which suggests that the allocations in my portfolio could certainly improve. My selection of companies was not as bad but still an area I could very much improve on.

Next Steps

My aim with this series of posts is to take you on my own learning journey and document how I am planning to organise my strategy going forward. My hope is that it will help some people look at their own portfolios and see if they could improve in any areas.

I would also hope that any experienced investors would chime in and offer some pieces of advice that they have learned. or point out any mistakes I may make throughout this journey.

Although I knew the name of each sector. I never really gave them much thought in terms of how they react in certain economic conditions. What my desired portfolio allocations should be and why.

I kept track of the allocation on my spreadsheet, But this was more of a tick box exercise which had no real meaning.

If you don’t know what your goals are! How do you measure your success?

For me, the next step was to learn about each sector and why they are important. Once I have a level of understanding I can begin to hopefully optimize my portfolio.

The Global Industry Classification Standard.

Developed by MSCI in 1999, the GISC offers a 4-tiered hierarchical industry classification system.  The Structure of the hierarchy is categorized as 11 sectors, 24 industry groups, 69 industries, and 158 sub-industries.  You will notice that each company in the S&P 500 will be assigned into a section in each one of these categories based primary activity of the business.

In this post, the focus will be mainly on the 11 sectors at the top of the hierarchy. These 11 sectors are

• Consumer Discretionary
• Consumer Staples
• Energy
• Materials
• Industrials
• Healthcare
• Financials
• Information Technology
• Real estate
• Communication Services
• Utilities

ICB

For those of you on my side of the Atlantic and are more familiar with the FTSE, might think that there are too many sectors above. 

That is because the FTSE has a similar 4 tier structure called The industrial classification benchmark. Although they are quite similar there are some differences which are something I might write about in the future.

This post will use the GICS standard as most of my shares are in S&P500 companies.

Consumer Discretionary

Often referred to as consumer cyclical, consumer discretionary stocks are companies which supply good and services that are deemed non – essential.

When an economy is thriving and there is plenty of disposable income, you can expect this sector to do fairly well.

Think about it, the more money you have leftover to spend, the more likely you are to spend on entertainment, clothes, and cars.

Consumer Staples

Considered the opposite of consumer discretionary. These companies provide products such as food&beverage and household goods.

As these are usually essential items, the stocks usually do not suffer from cyclical cycles.

I used the word usually on purpose as tobacco and alcohol fall under this group. Although not considered essential they are items that people will continue to buy. No matter their financial situation.

Energy

This category of stocks relates to companies that produce or supply energy. They will fall into one of two categories. Non-renewable like gas and oil or Renewables like wind power or solar power.

Materials

The materials sector is heavily linked to construction as these companies are involved in the development and processing of raw materials.

As a former electrician, I know from experience that construction can be cyclical. Thrive in a strong economy and struggle in a recession.

Industrials

Companies in this sector make machinery and supplies that are used to produce other goods.

Similar to materials they will Thrive in a booming economy but suffer during recessions.

HealthCare

Maybe an obvious one but the healthcare sector consists of businesses that provides medical goods and services.

As you can imagine, your health is important no matter what your economic circumstances are so these stocks would be considered non-cyclical.

Finanicials

When you hear the word financials. I bet you think of either a bank or Wall street!.

In Fact, the financial sector encompasses a broad range of industries such as banks, investment, and insurance companies.

Most of us that are old enough to Invest today will remember the last recession and the impact on the financial sector. This is another sector which is considered cyclical

Information Technology

I am not afraid to admit it but I am a nerd. I love technology hence this is my favourite sector.

The tech sector covers a wide range of goods and services such as PCs, Smart watches TV, Enterprise software and much more.

Companies that you might be familiar with in this sector are giants such as Apple,Google and Microsoft.

Real Estate

Real Estate falls into 3 basic categories. Residential , Commercial and Industrial.

There are lots of ways that you can invest in Real Estate. You can but a property directly. You can buy shares in REITs or you can even get involved in peer to peer lending.

Communication Services

The telecommunications sector consists of three basic categories, telecom equipment, telecom services and wireless communication.

As Technology advances the communication services are focusing more and more on video, text and data.

This sector is becoming increasingly more important particularly in this era of globalization where many companies are multi-national.

Utilities

Companies in the utilities sector provide basic amenities such as water and electricity.

These companies are important in terms of the public service landscape and are heavily regulated.

The utility sector tends to do well as defensive stocks in macroeconomic downturns.

Stock Structure

The explanation of each sector above was short. Each one would warrant a post of their own. But I hope you noticed that most were categorized into Cyclical and non-cyclical sectors.

Actually, each sector can be grouped into 3 categories or super sectors if you wish.

Defensive Super Sector

Sectors that belong in the Defensive super sector are ones that are not cyclical by nature.

This Super sector is made up of Consumer Staples, Health care, and Utilities. Basically, everything that your average person requires on a daily basis.

Companies you may be familiar with in this Sector is Coca Cola, Johnson&Johnson and Duke Energy.

Sensitive Super Stocks

 Sectors which fall in under the sensitive super sector fall between the defensive and cyclical industries.

This means that they are not as immune to a poor economy as defensive stocks. But they also may not be as severely impacted by a poor economy as industries in the Cyclical Super Sector.

The Sensitive sector is made of sectors such as Communication services, Energy and technology.

Companies you may be familiar with in this group are Verizon, Apple, Royal Dutch Shell.

Cyclical Super Sector

The last super sector is made up of sectors that are highly impacted by business cycle peaks are troughs.

When the economy is booming these industries tend to perform favourably. The opposite is also true when the economy is in a downturn.

The Cyclical super sector is made up of the remaining sectors. Materials, Consumer discretionary, Financials, Real Estate, and Industrials.

Companies you might recognize are Sonoco Products, Eaton Vance, Reality Income and Cisco

That is it for this week. Next week I will look at my own portfolio and examine my own allocation before defining my desired portfolio.

Thanks for reading and happy investing!

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