Within the stock market, stocks are grouped according to a hierarchy of increasingly precise classifications. This system of classification is very useful for the beginning investor, as well as the veteran, to facilitate both diversification of the portfolio and decisions regarding the allocation of assets. The hierarchical system, which is known as the Global Industry Classification Standard (GICS) was developed in 1999 by Morgan Stanley Capital International (MSCI) in conjunction with Standard & Poor’s (S & P). From 2006 until very recently, Dow Jones used the Industry Classification Benchmark (ICB) system, a competing, albeit very similar, method of classification; however, they adopted the GICS in the autumn of 2014.
Classification according to the GICS
Every stock classified according to the GICS, whether it is domestic or international, is coded at each of 4 different levels. These levels include 10 sectors (oil and gas, basic materials, industrials, consumer goods, healthcare, consumer services, telecommunications, utilities, financials and technology), further divided into 24 industry groups, 67 industries and 147 sub-industries.
Within this framework, companies are classified according to their principal business activity, as determined by what brings in the bulk of their revenue. To date, over 95 percent of all publicly listed stocks in 90 markets all around the world, totaling more than 26,000, have been classified by the Global Industry Classification Standard system.
The production-oriented approach vs. the market-oriented approach
There are two possible ways to classify industries for the purpose of identifying stock sectors. The first is the production-oriented approach, which classifies companies by what they produce, in terms of goods or services. This method may become unduly complicated because many companies produce both goods and services, often with a substantial degree of overlap.
The second is the market-oriented approach. This classifies companies by the role their products, both goods and services, play in the marketplace. An example would be the classification of consumer staples (goods such as food and housing which are necessities of life), as opposed to consumer discretionary (for instance hotels and automobiles).
The latter category is more likely to be affected by a slowdown in the economy.
Why stock sectors are important
Grouping stocks into sectors helps to provide a better understanding of trends within the stock market. If a particular industry is thriving – or, the opposite, floundering – stock prices throughout that sector will tend to reflect that movement. For this reason, a portfolio whose investments are diversified throughout a range of sectors is apt to involve less risk than if all the investment is concentrated in one limited area.
