Having built up a list of all the different sector classifications that we can use to build up a robust investment portfolio, we can start going through each of these industries to make sure that we are gaining a broad exposure throughout the entire industry itself. In doing so, we are again ensuring that we diversify our risk as much as possible, and only expose ourselves to the risks of the overall economy itself. This can be accomplished by digging into the specifics of the various companies that operate within the industries themselves, and determining what kind of business they are running, and what kinds of risks are associated with that particular line of business.
The first step to digging into a specific industry sector is to look into the various types of businesses that exist therein, and categorizing them. The easiest way to do this is to arguably use the fundamental weighting of cyclicality that we discussed in an earlier article. By defining companies in accordance to their performance with respect to the current business cycle, we can then look at the types of returns that these investment opportunities will produce.
For example, within the financials sector, we can see that we have a variety of different kinds of investment classes that will have different levels of returns. While the banks and diversified financials sub-categories will have heavily exposed to the business cycle because of their reliance on prevailing interest rates to earn a profit, the insurance category will be somewhat inversely related to this position, because low interest rates mean that they are better able to earn a return on their investments over the loan term due to the stimulus effect. Lastly, the real estate markets will also behave inversely to the banks because of the way in which a lower interest rate will support a higher property value, and therefore cause appreciation in the value of the assets held by the real estate companies.
Seeing how it is that the cyclical risks of our various asset classes inter-relate, we can then move on to look at how it is that our industry-portfolio will create different kinds of returns. Looking back at the financial industry, even though the industry appears to be fairly well balanced among those four types of investments, we need to remember that each one will provide a different kind of return.
While banks, diversified financial companies, and even insurance companies will provide very strong fixed income components of return, the real estate portion that counter-acts the interest-risk exposure of the portfolio will only produce an income return if it has some sort of rental lease in place. Otherwise, the only returns generated will come from capital gains in the properties themselves (perhaps if the assets are managed by a 3rd party company). This means that we need to evaluate just how much of our return from these various assets will be coming from fixed incomes, and ensure that it is balanced against the opportunity to earn capital gains from an opposite kind of position.
