Step 3: Identify Your Core Competencies

This is the third in a series of articles elaborating on the 9 Steps To Build and Manage a Dividend Portfolio.

One of the biggest problems when it comes to investing is confronting our own ego. Just like everyone thinks they’re an above average driver, everyone thinks they’re an above average investor. So, it’s important to make note of what kinds of businesses you readily understand and are capable of making educated long-term investments in, and which you are not. Deciding which dividend stocks and sectors to invest in is ultimately a matter that needs to be chosen by the investor, or between the investor and her financial adviser, but there are some things worth considering.

Areas that I particularly recommend caution are:
-International Stocks: Do you know the social issues, geographic risk, and demographics of the areas the company operates in?
-Large Banks: Teams of analysts and economists were unable to grasp the risk of large bank portfolios before the financial crisis.
-Technology: Can you truly predict which tech will catch on over the next five years?
-High Growth Stocks: Are you capable of making accurate long-term predictions of a company’s growth, or do you have to take analysts or management personnel on faith?

This is not necessarily a list of stocks to avoid- just a list of stocks that especially require you to honestly examine what you know and what you don’t know in my opinion. Some investors can target these areas and make good consistent returns. And there are ways of mitigating the risk for less focused investors. For instance, for international exposure, you can invest in companies that have diverse geographic operations. For the finance sector, you can go with smaller banks or more streamlined financial institutions. For tech, there may be some areas you’re knowledgeable enough in to make a substantial investment. For high growth stocks, one can spread out risk into several of them, perform extra diligence, and always invest with more conservative numbers than analysts predict. Index funds and ETFs can also be of help when it comes to diversifying.

A good place to look for investment ideas is to see what products and services you use in your own life. What leads you to them? What stops you from switching to a competitor? How could they be improved?

Sector Diversification

It’s important to be diversified into numerous sectors, but that greatly broadens the circle of competence required. Walking a path between over-diversification (in terms of number of stocks and variety of stocks) and under-diversification is the subjective and difficult part. During market cycles, some sectors will greatly underperform compared to others, so being too concentrated in one or two sectors increases risk. For instance, over these past two years, health care companies have greatly underperformed compared to energy.

The Primary Sectors are:
Basic Materials
Capital Goods
Conglomerates
Consumer Cyclical
Consumer Non-Cyclical
Energy
Financial
Healthcare
Communications
Technology
Transportation
Utilities

One might not necessarily need to invest in all of them, but diversifying into at least several of them is important to reduce overall portfolio volatility and to reduce risk of making wrong assumptions about any given sector. It’s not just about short-term balancing either; some sectors can have very long bouts of poor performance.

A good step to improving your portfolio might be to review each sector, picking out several top companies you are familiar with from each one, and to begin from that reduced list to select investments you think are worthwhile and that you can honestly say are within your field of understanding. Make a note of which sectors you find a lot of familiarity in. There’s no shame in only having a few knowledgeable sectors- even Warren Buffett only invests in a few of them. But it’s important to be fairly diverse, and sometimes broader funds can help your portfolio be more diversified than only your core competencies allow.

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Comments

  1. Good stuff. My competence zone is getting more and more narrow. I have stopped investing in emerging markets funds and tech. Lately Ive been considering selling off stocks with all their operations abroad. It is easier to keep updated (newspapers etc) and in many cases it allows “fieldtrips”. This is one of the reasons i steer away from american insurance stocks despite they seem like good value.

    Another area were i would recommend caution is smallcap. Graham recommends a specific minimum market cap as smallcaps carry more risk, they are unproven and fail more often.

  2. Great article!

    I believe in an almost old-fashioned type of investing. I started investing in Coca-Cola because I drink it everyday, I invested in MCD because I enjoy the food. Most of my portfolio consists of companies that produce products that I buy or products that people I personally know buy. The only company that really falls outside this in my personal portfolio is TEF. But, my girlfriend is from El Salvador and she says this company is growing like crazy in Latin America. Of course, I don’t rely on my girlfriends conversations to make investment decisions, but you see where I’m going. Invest in what you know.

  3. Nice post Matt.

    I’m with defensiven – I don’t buy tech. Too many highs and lows for me.

    I do invest in emerging markets, but via ETF, VWO which comprises <5% of my overall portfolio.

  4. I won’t touch tech for the most part.

    I’ll play emerging markets when the institutional numbers work for decent carry trades. As a small investor, having the wind created by the “big boys” behind my position gets me excited. That said, emerging markets are best played with individual stocks, in my opinion, as retail investors are far too keen on loading up on ETFs on any sign of central bank policy shift/government spending decision.

    ETFs have done a lot to bring the market to the individual investor, but they’ve also done a lot to bring the stupid of the individual investor to the market.

  5. Awww…small cap haters? If you’re not looking into small cap stocks that are illiquid then you’re passing up one of the few advantages you have over the institutional investors! Microcaps are a goldmine, you just have to have the patience to grab a shovel and start digging!

  6. Matt, I agree with your general point that you should be extremely careful investing in companies that you don’t or can’t fully understand. I think the big banks example is a perfect one there. In a lot of cases they don’t even know what their balance sheets really hold.

    The flip side of that coin is that the deeper you can come to understand a company, its industry, strategy, and management, the more comfortable you should be investing in it. That’s why I limp into all my stock purchases, buying a small amount and paying close attention for the next few quarters. If my understanding of the company grows and if I see management executing on their strategies, then I buy my second and third section, building up a more or less “full” position. That makes investing in a company much more of a process, I think, then a decision. The great part about that is that we can always get better at it!

  7. Excellent post! I also stay away from tech companies, automotive manufacturers, and airlines. I like recession-proof industries.

Trackbacks

  1. [...] Identify Your Core Competency @ Dividend Monk [...]

  2. [...] Dividend Monk wrote an excellent article about identifying your core investing competencies. [...]

  3. [...] of the articles for April were: Five Quirky Portfolios For An April Fool Step 3: Identify Your Core Competencies Johnson and Johnson Analysis Abbott Labs Analysis Step 4: Socially Responsible [...]

  4. [...] Nobody is an expert on everything, and yet investors should have a reasonably diversified portfolio. Identify a few sectors that you feel you have a solid understanding of, and use those as your primary means of diversification. If all of your stocks are too concentrated in one or two sectors, then a single unexpected macro-economic trend can dominate your portfolio. While I don’t recommend over-diversifying, it’s important to spread risk and reward into a few different sectors while remaining in your circle of competence. Read the Full Article on Step 3 [...]

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