Sometimes in investing there is a tendency to over think things, to get bogged down in the details, to lose the forest through a close study of the trees. It is not that such matters are irrelevant, but that if you get the big major questions right you will be most of the way there.

Unfortunately, most investors tend to avoid even asking the big really important questions, or at least don’t act on them. The big questions really tend to boil down to what sectors you should be investing in. Yet, many investors simply rely on indexing instead. Even worse, those that do not explicitly index often invest in mutual funds that “closet index”.

Investment managers will do that because there is a big premium put on not being too far away from the “bogey”, usually the S&P 500. Sure, it’s great if they are substantially better than the index on the upside, but the consequence of sharply lagging, even for only one year, is that you get fired.

The end result is that much of money management turns into the relentless pursuit of mediocrity. It turns out you can make a very good living just mimicking the overall index. After all, the majority of active managers actually underperform the S&P 500 over any given five year time period. Being down 10% when the market is down 8% will not get them fired; however, being up 15% when the market is up 25% will.

In any given year, most fund managers don’t underperform by all that much. The reason is that their sector allocations tend to be very close to that of the overall index, and they have overhead costs that eat into the returns. They will then spend a huge amount of time and effort trying to decide if they should buy Exxon Mobil instead of Chevron, Proctor & Gamble or Colgate. The fact is that most of the time, if Exxon is going up, then so is Chevron, and by very similar percentages. Both will tend to be driven by the price of oil. However, if your goal is to beat the market by 1% or 2% per year, and not underperform it by that much, then making the right choice between XOM or CVX can make the difference. If your objective is to create real wealth, you are spending lots of effort for minimal results.

There is a reasonable case to be made for actual indexing, since it aims to lower the overhead costs and, over time, that adds up. There is not much good that can be said for closet indexing. Despite that, it is done all the time, not because it is good for the investor, but because it is a very safe choice for the manager’s job security. Just because at the start of 2000 over 30% of the S&P 500 market value was in technology was not a very good reason to have 30% of your money there when some of those stocks were selling for over 30X SALES! But that is what all those closet indexers were buying.

However, if really believe indexing is the answer (because of low costs), I doubt you would be reading this. Just send your money to Vanguard and forget about it. You will not beat the market, but you will not underperform it, and you don’t have to pay a lot for it. On the other hand, you are not going to build real wealth that way.

In effect, people took a very good idea, diversification way too far. The reduction of risk (volatility) you get by holding 50% of your assets in one stock and 50% in another is huge. This is particularly true if the stocks are in different industries. But having 101 stocks in your portfolio rather than 100, does not meaningfully reduce your risk. Buying a little bit of everything is fine if you don’t really want to work at it, but it will not make you wealthy.

This isn’t to say that stock selection counts for nothing.  But most of the time within major industry groups the difference is minor compared to the difference between the major groups. For example, look at the chart below that shows the performance of Exxon, Chevron, Citigroup, and Bank of America over the last 3 years. While it is true that you would have preferred to be in CVX instead of XOM over that period and in BAC instead of C, but really, the important decision was to be in oil instead of banking.

To take another example, here is the same sort of chart with Coca-Cola, PepsiCo, Macy’s and JC Penney on it. Again the big question was not do you want to have a Coke or a Pepsi? It was would you rather be in soft drinks or department stores?

Picking the right stocks within a group can be very hard to do. Getting the big questions right is not always easy, but can be done with a good understanding of what is happening in the world around you. Since most of your relative return is going to be decided if you are in the right industry, not the right stock within that the industry, doesn’t it make sense to spend most of your effort trying to figure out which is the right industry?

The differences in returns between companies in the same industry is in large part determined by the details of their capital structure, the quality of their management, and perhaps their ability to come out with successful new products. Unless you have a lot of time on your hands this can be hard to figure out. Fortunately, the analysts on Wall Street spend all their time focusing on those sorts of details. The most significant items will ultimately find their way into the income statement. The best way to keep track of if things are improving or deteriorating is to see if the analysts are raising or lowering their expectations for future earnings. The Zacks Rank does a very good job of this.

The differences between industries are driven much more by the big trends in the economy. Is the price of oil going up or down? Is the dollar going to be weak or strong? Is inflation going to increase or decrease? Is the economy going to boom or bust? Are consumers in a mood to spend or save? Answering these questions right depends on an understanding of what is happening in the world around us, and then understanding how each of those sorts of questions will affect different industry groups. Getting the big questions right leads to asking the right questions about the little picture. Answering them right leads to big returns.

If you just want to try to beat the market by 1% a year, then weight your portfolio with the same weights that the S&P 500 has and then spend all your time worrying about Coke or Pepsi. If you want real wealth, focus on the big questions. But it’s not easy because economics, politics and the stock market are not exact sciences. So if you have a great track record at gauging these 3 areas over time, then I salute you. If not, then you might need some help from folks who do understand these things and have a good track record. Oh yeah, I’m talking about myself.

Think about how much you would have made buying homebuilders in 2000 and riding the wave until 2006. It didn’t really matter if you bought Centex or Standard Pacific, you would have made a fortune. I was a portfolio manager then and had the most I was allowed to have in a single industry (per the prospectus) in the group. I am also on record telling people to get out of the group in the middle of 2006, saying the housing bubble was going to burst. 

That is what drives our Strategic Investor, the new Zacks service I’m directing. If you have ever read my Strategy Report, you know that I spend a lot of time thinking about those big questions and predicting how they will affect different industries and sectors.

My track record in this regard has been well documented. As early as late 2005, I was urging people to invest in Energy and Commodities. In the middle of 2007, I was pointing out the huge risks to the financial system from the bursting of the housing bubble. In early 2008, I warned that raising the conforming limit was putting Fannie and Freddie in grave danger. At the time, most of the Street was saying things were “contained”.

In the Strategic Investor, I will be striving to continue to get the big questions right. I will also answer them with specific investment recommendations aimed at substantial long-term profits. You may want to look into this service today because a significant savings opportunity ends after this weekend.

Click here for more details about the Strategic Investor.

Dirk van Dijk, CFA

With more than 25 years of experience as an analyst and portfolio manager, Dirk is Zacks’ Chief Equity Strategist. He regularly authors market strategy reports and articles, and appears on many investment TV programs. He also manages the new long-term investing service, Strategic Investor.Zacks Investment Research