Sector classification in stock markets: a latent class approach

Stock indices related to specific economic sectors play a major role in portfolio diversification. Notwithstanding its importance, the traditional sector classification shows several flaws and it may not be able to properly discriminate the risk-return profile of financial assets. We propose a latent class approach in order to correctly classify the stock companies into homogenous groups under risk-return profile and to obtain sector indices which are consistent with the standard portfolio theory. Our results allow to introduce a methodological dimension in the stocks classification and to improve the reliability of sector portfolio diversification.