A Question About Investing & Diversification

simple trading

TMN asks:

I want to (re)start investing and I have a question. Don’t you think it’s more prudent to study one industry or sector in depth and then invest exclusively in that sector or closely related sectors? I know that diversification is important especially if you have a very long-term horizon like I do, but I just can’t shake the feeling that you’ll never really get it right unless you know everything there is to know, and how can you do that when there are millions of companies operating in hundreds of industries? Besides, if the industry allows surely you can diversify within it? Thoughts?

TAOST: Diversification is a risk management tool… but there are others… If it’s growth you seek, you’re on the right track. If you notice, the best traders/investors (best absolute performance) focus on a narrowly defined sector or asset. Match appropriate risk management tools with whatever sector/asset/approach you choose and have at.

Good trading.

TMN: Thanks. I prefer to work in a systematic way, so I’ll definitely end up placing criteria on my investments. So things like this matter to me:

  • Very low P/E (<11)
  • Must pay dividend with healthy yield and have uninterrupted history of paying said dividends
  • Preferably small-cap or mid-cap
  • Must demonstrate growth-oriented (e.g. mergers, acquisitions, patents, R&D, etc.)
  • Must not be in saturated market

You get the idea. But here’s where it gets muddy:

  • Industry must have prospects as well as company

This sucks because growth is a two-sided coin. On the one hand, I would prefer to be in a growth industry in bullish times like now, and in a mature industry in bearish times. The problem I’m having is in bridging that divide. In other words, I want to have a “narrow” focus like you put it but I feel it would be best to get into two or three different sectors, with varying levels of risk. Say, green tech for high risk, database infrastructure for medium risk, and agriculture for low risk (these are just examples, I know each has challenges). In your opinion, would this be a good idea? Keeping in mind that I want slow, steady growth, but growth nonetheless.

TAOST: I would be interested to see how many candidates this type screen presents on a regular basis.  There are lots of fundamental crosswinds that might present a problem… For example, the criteria you laid out include elements of both value, high growth and mature stocks.   At any rate, while I understand company fundamentals, they are not my area of expertise, so I will leave that piece to someone better suited to the task.  As for risk management (which is my area) there is no reason that your overall approach can’t be  effective (assuming sufficient candidates present).  Just be sure to give LASER FOCUS to your overall and per trade risk.  Forever is a great holding period as long as your assets are working on your behalf (moving higher generally). But, like most team sports, defense is where the game is ultimately won.  Risk management/control is the ultimate defense for traders/investors.

Good luck and good trading.