It is tempting to build a portfolio containing stocks from a wide range of industries. For instance, an investor could see opportunities to make high returns across a variety of sectors, or may wish to achieve a high degree of diversification.
However, dabbling in a wide range of industries can be problematic. It may even lead an investor to miss out on the most appealing buying opportunities available.
Therefore, in my view, focusing on a more limited range of sectors could be a better idea. It may allow an investor to build specialized knowledge that leads to a competitive advantage over their peers.
Building a circle of competence
It is difficult to gain detailed knowledge across multiple sectors. For example, an investor may need to understand the history of a specific industry, as well as current trends and the key drivers of its future performance. They then need to understand the business models of the various companies operating in a sector in order to ascertain which stocks are the most compelling investment opportunities.
This process takes time. Therefore, it is unreasonable to assume that any investor can quickly gain such detailed knowledge over a wide range of industries. Without specialized knowledge, an investor may fail to fully understand the risks facing a specific sector or company. Likewise, they may be unable to spot which companies are undervalued based on their economic moats and financial position.
By contrast, specialized knowledge may make it easier to unearth value investing opportunities within a specific sector. This may lead to a more productive use of capital over the long run.
The practicalities of acquiring specialist knowledge
One value investor who has always sought to invest only in industries that they fully understand is Baupost Group cofounder Seth Klarman (Trades, Portfolio). As he previously stated:
"My view is that an investor is better off knowing a lot about a few investments than knowing a little about each of a great many holdings."
In my opinion, Klarman's statement is highly relevant. However, there are practical challenges facing any investor who is aiming to build specialist knowledge in specific sectors.
For example, investing in a limited range of sectors while building knowledge of other industries can lead to a lack of diversification within a portfolio. This may lead to heightened industry-specific risk, as well as greater company-specific risk that reduces long-term returns.
Meanwhile, holding cash as an alternative to investing in a limited range of sectors while learning about different industries may cause a significant opportunity cost. Today's rising stock market plus low interest rates could test the patience of any investor.
A simple solution?
In my view, a sound solution could be to invest a portion of a portfolio in an index tracker fund while acquiring knowledge about specific industries. This would avoid missing out on the stock market's growth prospects, while providing sufficient time to build areas of expertise.
Over time, a growing proportion of the portfolio could be directly invested in stocks, instead of a tracker fund. This may produce a more attractive risk/reward opportunity over the long run. It may also help to avoid the risks inherent in investing in a wide range of industries without having specialized knowledge of them.
Disclosure: The author has no position in any stocks mentioned.
Read more here:
- Mohnish Pabrai: Patience Is Your Most Valuable Asset
- Bill Ackman: Invest Using Fundamentals Instead of Emotions
- Peter Lynch: Buying Familiar Stocks Can Be Dangerous
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