Theme investing, particularly when snatched from the latest headlines, may seem appealing—but more often than not will lead to poor returns

Theme investors zero in on something that’s going on in the world—in business, politics, technology or society as a whole—and try to cash in on it, directly or indirectly. You can get lucky with trendy theme investing, but there’s a large element of risk. Interest in the theme may slump sooner than you expected. Or, your enthusiasm for the theme may lead you to drop your guard. It may spur you to put money in stocks or other investments that are drastically over-priced or fundamentally flawed.

Focusing on a theme that’s in the headlines can help you identify potentially high-profit investment and business opportunities. But trying to cash in on a theme is inherently risky.

An example of theme investing in the resource sector

For example, the rising price of gold was a popular investing theme during much of the first decade of this century. As gold rose from under $300 to more than $1,800 per ounce, it presented a wide variety of profit-making opportunities. But the rising price of the metal was no guarantee of profit. Gold-themed investments—collectors’ coins, penny stocks, gold-based futures and options trading—gave promoters lots of ways to create low-quality investments to sell to gold-seeking investors.

Theme investing within the green energy market

Green energy comes from renewable resources like solar power, wind power, geothermal power and generating electricity from ocean waves. Green energy investing has become more popular in the past few years, as concern over the environment has grown.

Green energy can be considered to be an investment theme. However, as with all investment themes, we’ve always recommended that you choose green energy stocks very carefully to profit. That’s because many of these companies have only limited investment appeal.

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Investors interested in green energy should know that these firms often need a long time to move from the research or concept stage to profitability. As well, governments often cut subsidies for renewable energy development when they struggle with high budget deficits.

To cut your risk, we recommend that you focus on green energy stocks that already have a sound base of other operations, preferably businesses that provide steady revenue streams. That helps offset the risks of expanding into renewable-power production.

Avoid theme investing in ETFs or mutual funds

If the ETF or mutual fund’s theme seems to be plucked from recent headlines, stay away. It pays to stay out of narrow-focus, faddish funds, all the more so if they’ve come to market when the fad dominates the financial headlines. Good examples are ETFs or other funds that invest in cryptocurrencies or related firms.

Trendy theme funds like these face a double disadvantage because they appeal to impulsive investors who pour in their money just as the fad hits its peak. This forces the manager to pay top prices— perhaps to bid prices higher than they’d otherwise go—even if this goes against their better judgment. These same investors are also apt to flee when prices hit their lows, forcing the ETF or mutual fund manager to sell at the bottom and lowering the fund’s performance. But when a fad fades, as they all do, the fund’s liquidity dies out with it. The manager may have to dump the fund’s holdings when demand is at its weakest, forcing prices lower than they would otherwise go.

The appeal of theme investing tilts the odds against you in two ways

First, the appeal of hot themes attracts naïve investors. They, in turn, bid up the prices you have to pay to invest.

Second, the excitement surrounding the theme attracts opportunists who simply want to create investments and business ventures that are easy to sell, regardless of their chance of long-term success. This cuts the average quality of available investments.

To top it off, you need to remember that the gold and green power themes (such as solar) of the previous decade turned out to be particularly powerful and long-lasting. Future themes may end much more quickly. It’s hard to imagine a worse investment situation than buying a low-quality, over-priced stock because of its connection to an investing theme just when the popularity of that theme is about to evaporate.

Bonus tip: Avoid stock investment clubs that form to focus on theme investing

Let’s say you join a club that picks up on one or several investment themes or fads. You could feel pressure to do the same with your personal investments. (The risk with theme investing is that you could let the theme or fad become your overriding investment consideration—and that could distract you from other measures of value and risk).

We would strongly advise that you look for an investment club that follows a reduced-risk, conservative strategy like ours.

The best way to learn how to invest in stocks with less risk within the framework of an investment club is to join a group whose philosophy has something in common with our three-part Successful Investor approach. Our philosophy is to invest mainly in well-established, dividend-paying companies, to spread your money out across most if not all of the five main economic sectors (Manufacturing & Industry; Resources & Commodities; Consumer; Finance; and Utilities); and to avoid or downplay stocks in the broker/media limelight.

Theme investing often favours small-caps with emerging businesses. These themes may be short-lived or too narrow. What characteristics would convince you to invest in themes?

Share a situation where theme investing has paid off for you as an investor?