Many investors try to become experts in a wide range of sectors. For example, they may seek to build a portfolio that contains 30 stocks from 15 different industries. Developing knowledge on the key catalysts and risks within each of those sectors can be challenging for even the most committed and intelligent investors.
Therefore, it may be prudent to instead focus on a smaller number of industries. This may enable an investor to build a more detailed and thorough understanding of their appeal. It could make it easier to find the most attractive businesses that operate within them.
It may also allow an investor to quickly capitalize on low valuations that may only be present for a short period of time, such as during a market correction. An investor with detailed knowledge of an industry may not need to undertake further extensive research before purchasing a stock.
This viewpoint has previously been discussed by Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) vice chairman Charlie Munger (Trades, Portfolio). As he once said:
“It's not given to human beings to have such talent that they can just know everything about everything all the time. But it is given to human beings who work hard at it—who look and sift the world for mispricings—that they can occasionally find one.”
Backing your judgment
In my view, it is also important for investors to back their judgment when they find a rare instance of a high-quality company trading at a low price. Otherwise, they could miss out on its long-term return potential and instead allocate capital to less appealing opportunities.
Clearly, this view is easier to follow in theory than in practice. Indeed, it can be difficult to go against the views of other investors and buy a stock that you believe is significantly undervalued by the market. However, as Charlie Munger (Trades, Portfolio) has previously stated, it is imperative to grab those limited number of buying opportunities during a lifetime:
“The wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don't. It's just that simple.”
Diversification
Of course, investors who back their judgment may end up purchasing only a limited number of stocks during their lifetime. This could lead to a very concentrated portfolio. In turn, this may cause disappointing portfolio returns should their analysis prove incorrect, or some one-off event occurs that hurts the performance of a small number of their holdings.
Therefore, in my view, it is important to build a diverse portfolio at the same time as backing your judgment on the relatively small number of investment opportunities that come along during a lifetime.
A simple means of doing this could be to purchase index tracker funds alongside a small number of high-conviction ideas within a portfolio. This could create a best-of-both worlds scenario, in terms of offering diversification benefits while not requiring an investor to build detailed knowledge about a wide range of industries in order to diversify.
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