Sector investing refers to types of investments which focus on many companies within a single broad economic sector (sometimes as narrow as an industry, but alternatively as broad as multiple industries which follow, or track, a few key indicators). Sector investing allows the potential of much greater returns if a sector generally does much better than the economy as a whole, at the risk of producing much poorer returns if that sector is outperformed by the economy as a whole, or even suffers a serious disastrous event, as has happened to the oilfield drilling and services industries since the BP oil spill in the Gulf of Mexico.
In general, people hoping to grow their money on the market for long-term savings are advised to diversify as much as possible, to produce moderately good gains while minimizing the risk of a disastrous collapse of their investment portfolio. For this reason, mutual funds which hold shares in a large number of companies (or, ideally, shares in multiple mutual funds) is seen as much preferable to investing in a single company, which may grow quickly but could also fail spectacularly. Having holdings in multiple companies means that one can benefit from the rapid growth of some companies and survive the collapse of others.
Diversifying, however, is not nearly as simple as it sounds. Short of buying stock in every publicly traded company on the Earth (or at least buying shares in an index mutual fund or an equity-traded fund which does so), one can diversify only to a limited extent, putting more money into certain regions, or certain countries, or at least certain industries. It is this latter component where sector investing comes in. Investing in, say, the financial sector amounts to an informed gamble that the financial sector will do better over the next ten years than the economy as a whole, and hopefully also better than other sectors which could have been invested in instead. At this level, investments are more diversified than they would be by just investing in one or two companies, but are not truly diversified in the sense that a range of holdings in different sectors, countries, and regions would be.
Like investing in countries, regions (emerging markets, Europe, etc.), or types of companies (large cap or small cap funds), sector investing can be pursued through a variety of investment instruments, including mutual funds that specialize in specific industries, or index funds or equity-traded funds that track specific sectors with less active trading, but (as a result) at lower overall cost. Actively traded mutual funds buy and sell shares in a range of companies based on the fund manager’s estimates of which are most likely to generate high returns. In contrast, passive funds track a publicly available index of stocks. For instance, the Philadelphia Oil Services Sector Index (^OSX) tracks fifteen of the largest companies in the oil drilling and oilfield services industry, like Halliburton (HAL), Schlumberger (SLB), and Transocean (RIG). The NASDAQ composite index is technically only an index of the major companies on the NASDAQ stock exchange, but is often seen as a useful index for tracking the computer and software industry, since technology companies dominate the NASDAQ exchange.
The Philadelphia Oil Services Sector Index, referenced above, is a useful example of the potential benefits and risks of sector investing. The index charts the largest companies in the onshore and offshore drilling industry, and therefore performed very well when the price of oil was high and new production was coming online regularly. However, the index was devastated by the fall in oil prices during the recession, and was then devastated again by the BP oil spill of 2010. The recession had serious effects on many industries, but the BP oil spill particularly affected only BP and related oil production companies. (Furthermore, BP’s partners at Deepwater Horizon, Halliburton and Transocean, are major components of the index.) A more diversified portfolio with holdings in many sectors might have resulted in fewer gains than a fund tracking the oil services index in good times several years ago, but also would have escaped the carnage of spring and summer 2010 largely intact.