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?
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:
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.