Brokers like theme investing because it gives them a rationale to recommend new stocks or ETFs to their clients. However, this could be harmful to their portfolios.

Theme investing has a natural appeal. It simplifies things. Investors like it because they feel it can put their investment returns into overdrive. Some also feel it adds fringe benefits to their investing, by letting them support social or environmental objectives.

Brokers like it because it gives them a rationale to recommend a variety of stocks.

As an example, if a client thinks gold prices are headed up, a broker can think of all sorts of gold-themed investment opportunities. They include established gold miners; junior gold companies that are working on a promising gold property; or penny golds that are outright speculations. Other possibilities are financial companies that sell gold-related merchandise like gold coins.

If the client supports environmental causes, the broker can propose investments with a “green theme”. They may include solar-power equipment makers; companies that claim their products are less harmful to the environment than competitors’ products; or companies that claim to operate with a high degree of environmental concern.

When you focus on theme investing, however, it’s easy to overlook the fundamentals. If you’re sure gold prices are headed up, for instance, why trouble yourself with tiresome matters like finances or geology?

Of course, many investing themes carry a grain of economic sense. Government spending deficits and money-supply growth of recent years will eventually lead to a rise in inflation. Gold may rise in response. The sun could one day become an economically attractive power source (though it now mainly runs on government subsidies). But it takes more than a grain of economic sense to turn a company into a profitable investment.

In the 1950s, some shoe stores kept a specialized x-ray machine on the sales floor. The ads on the store window said you could use the machine to check the fit on a new pair of shoes before buying them. Critics called it a gimmick to speed up shoe sales, and warned about the risk of needless exposure to x-rays.

Something like this happens today in the investment business.

For instance, finance industry marketers have discovered that ETFs are a potent selling tool. It can attract buyers for all sorts of theme investing schemes that would otherwise have little chance of success.

The Global X Social Media ETF is a good example:

This particular ETF gives you an easy and low-cost way of investing in stocks associated with the “Social media” investing theme. These stocks are now in the broker/media limelight. That’s not a particularly good time to buy. By the time the media has identified an investment theme like social media, and the investment industry has begun offering ETFs and other short cuts to investing in it, the best opportunities may have already come and gone.

Stocks that are in the broker/media limelight tend to expose you to extra risk. That’s because the favourable attention they get in the limelight pushes up investor expectations. When these stocks fail to live up to those heightened expectations, and that always happens eventually, stock prices can plunge.

Global X Social Media ETF isn’t in the limelight. But the stocks it invests in certainly are. That means some of the stocks it holds will eventually plunge when they fail to live up to investors’ heightened expectations.

All themes revolve around predictions. That’s the hard way to make investment decisions, and is likely to lead to expensive mistakes. That’s why we focus on well-established companies. You can spot these companies mainly by description, rather than prediction.

Many views about the future turn out wrong. Well-established companies are most likely to survive the inevitable setbacks and thrive all over again when good times return, as they always do.

Have you included theme investing in your portfolio? Let us know what “themes” you invested in, the comments.