Stocks

Stock diversification can become a science unto itself, with common stock groupings including U.S. stocks, international stocks, emerging and frontier market stocks, large-caps, mid-caps, small-caps, dividend stocks, growth stocks, value stocks, and a plethora of indices to represent every investor mindset from sector-specific to inverse leveraged correlation. Fortunately, creating a diversified stock portfolio is not as complex as it may seem at first glance.

Study Objectives

  1. Define stock sectors for portfolio diversification
  2. Consider emerging markets
  3. Explore portfolio construction with stocks

Stock Sectors

Stock sectors refers to the broad grouping of publicly traded companies by business type. It is advantageous to consider stocks by sector in order to analyze price movement correlation across and between business types. 

Created by index providers MSCI and Standard and Poor’s, the Global Industry Classification Standard (GICS) is the primary financial industry standard for defining stock sector classifications. The GICS segments the stock market asset class into 11 sectors represented by 24 industry groups, 68 industries, and 157 sub-industries. For our purposes, we are most interested in the 11 stock sectors.

The 11 broad GICS stock sectors commonly used for reporting include the following:

  1. Energy
  2. Materials
  3. Industrials
  4. Consumer Discretionary
  5. Consumer Staples
  6. Health Care
  7. Financials
  8. Information Technology
  9. Telecommunication Services
  10. Utilities
  11. Real Estate

While the GICS has organized stocks into their relevant sectors, the savvy investor will notice that, were one to invest in all the above sectors and consider these assets as part of our diversified portfolio in total (remembering our modern day “permanent portfolio”), duplication would be found in: Energy, Materials, and Real Estate. While energy and materials companies certainly can be stocks, price movements are also closely correlated to the commodities to which they have exposure. Therefore, we will eliminate these two sectors for further consideration in the commodities asset class section. Likewise, real estate as a sector will be considered in the income asset class section of this book, as these are primarily income producing assets with high levels of interest rate exposure.

Finally, in an effort to keep the stocks portfolio clean and simple, the author is eliminating the utilities sector, which is a hybrid commodities-income play. We are left to consider the following seven sectors for our diversified stocks portfolio.

  1. Industrials
  2. Consumer Discretionary
  3. Consumer Staples
  4. Health Care
  5. Financials
  6. Information Technology
  7. Telecommunication Services

Emerging Markets

The primary emerging market regions include Africa, Asia (Southeast, South, etc), Eastern Europe, Latin America, and the Middle East. Some further divide emerging markets with particular risk into a sub-category called “frontier markets.” Emerging markets tend to represent riskier, less liquid investments.

When considering emerging markets for a portfolio, ETFs represent the most convenient investment option in terms of liquidity and market diversification. Some investors prefer to allocate capital to represent their own thought process on the growth of emerging markets. In this case, region-specific ETFs may be more appropriate than a single diversified emerging market investment.

Portfolio Construction

Armed with a knowledge of what stock sectors are, why they are important, and which to consider for a diversified portfolio, how does one begin to invest? What are the options and how should research be started?

Stock Sector-Specific ETFs

ETFs are a great way to look at stocks sector by sector. Let’s consider the sector-specific ETFs below (the ETF is indicated with a “cash-tag”). One may notice that many of the ETFs listed below are Vanguard ETFs … this is because Vanguard is both well established and well managed. Sector-specific portfolios:

  1. Industrials – $VIS, $ITA
  2. Consumer Discretionary – $VCR, $PEJ
  3. Consumer Staples – $VDC, $XLP
  4. Health Care – $VHT, $IHI
  5. Financials – $VFH, $IYF
  6. Information Technology – $VGT, $XLK
  7. Telecommunication Services – $VOX, $IYZ

Don’t forget that a truly diversified portfolio includes other asset classes beyond stocks. Perhaps the reader should consider one holding from each sector to start, and build from there? Meant as an example and not as investment advice, were this author to select one company from each sector with which to build a starter stock portfolio, his portfolio would include the following holdings:

  1. Lockheed Martin ($LMT) = 2.97% dividend yield
  2. Walt Disney ($DIS) = 1.53% dividend yield
  3. Walmart ($WMT) = 2.15% dividend yield
  4. Pfizer ($PFE) = 3.45% dividend yield
  5. JPMorgan Chase ($JPM) = 3.00% dividend yield
  6. Cisco ($CSCO) = 2.63% dividend yield
  7. AT&T ($T) = 6.65% dividend yield

With the seven stocks above in one portfolio, an equal-weighted investment would yield 3.20% as an annual dividend. This is in-line with the dividend investor’s 3.00% annual yield goal.

So, What’s the Point?

In consideration of investment simplicity, low management time, little research time, reduced complexity in portfolio rebalancing, and a potentially small starter stash for building our diversified portfolio, the author is choosing two specific ETFs over individual stocks. It is important to understand the beautiful simplicity of owning fewer of the right assets than many of the wrong ones.

Get the book What is Investment Diversification? to learn which ETFs the author has chosen.

Next…

Now, let’s take a look at income assets in the next study guide.

Terminology

Blue-Chip Stocks
Stocks in corporations with national reputations for quality, reliability, and the ability to operate profitably in good times and bad. 

Cyclical Stocks
Stocks that rise and fall with economic cycle and are affected by macroeconomic changes.

Defensive Stocks
Stocks that provide a constant dividend and stable earnings regardless of the state of the overall stock market. 

Emerging Market
A country that has some characteristics of a developed market, but does not satisfy standards to be termed a developed market. This includes countries that may become developed markets in the future or were in the past.

Exchange Traded Fund (ETF)
An investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds and generally operates with an arbitrage mechanism designed to keep it trading close to its net asset value, although deviations can occasionally occur.

GICS
Standard and Poor’s “Global Industry Classification Standard” is an industry taxonomy developed in 1999 by MSCI and Standard & Poor’s (S&P) for use by the global financial community.

MSCI Index
The MSCI Index is a measurement of stock market performance in a particular area. MSCI stands for Morgan Stanley Capital International, the first global market indexes, created in 1968. 

Stock Sectors
The stock market is often divided into 11 major sectors representing key areas of the economy. 

Sources

  1. Research tool from CNN Business for sector price movement correlations   https://markets.money.cnn.com/Marketsdata/Sectors
  2. Morningstar used for yield and holdings data  https://www.morningstar.com/