Do Not Invest In Sectors
This is a common occurrence. You heard people say that 'the real
estate sector is hot' or 'the internet sector is growing
rapidly' or 'let's buy the oil sector now. Energy price will
rise again' next year. Sounds familiar? It is. This is because
these people encouraged you to invest in specific sectors.
What is wrong with sector investing? There is a common believe
that rising tide will lift all boats. Therefore, when internet
search is hot, then every companies in the field from Google to
Looksmart will rise two to three folds, right? Wait a minute.
Have you looked at the graph of Looksmart lately? If you
haven't, here is the two year graph of Looksmart Ltd. Let me
show you another example. Everybody knows about the rising
energy price, most notably oil. Therefore, if you look at the
five year chart of energy companies from Chevron and the like,
you would expect similar upward trajectory movement, right?
Wrong. Take a look at a five year chart of an energy company
IvanHoe Energy Inc. here.
So, should we look at sectors when investing? Absolutely. Sector
search is very useful during your preliminary research. Auto
sector is down. This might be a good place to find stock
bargains, right? Yes. Should we blindly invest in any stocks in
the auto industry? The answer is no. This goes back to the
purpose of an investor. Investor exists to make the greatest
return of assets possible while minimizing risk. The sensible
way to do that is to compare investment alternative and pick the
investment vehicles that may give investors the highest return.
In the case of stock, we are looking at the expected profit of a
company with respect to its stock price. This is the basis of
the return on investment of stock investors.
Therefore, once you identify that the auto sector is a bargain,
your homework continues. You should find companies that can give
you higher return than the risk free ten year treasury bond.
Currently, the ten year is yielding 4.52%. Since 4.52% is risk
free, we need to find stocks that can yield more than 4.52% for
the foreseeable future. Yield on a common stock can be
calculated by dividing earning per share (EPS) with the stock
price. If you invert this ratio, you will get the most commonly
discussed ratio in the investment community, Price Earning (P/E)
ratio.
Sector search is very useful in identifying future investment
prospect. However, do not just blindly invest in stocks in
specific sector. In the long run, stock price is correlated with
the amounts of profit it can produce. Stock price does not
correlate to the performance of other peers in the industry.