It’s some of the most common advice for investors seeking fortunes on Wall Street: “Invest in what you know”.
The idea was coined by famed investor Peter Lynch and remains one of the most widely espoused mantras by both Wall Street pros and individual investors alike. It’s a simple concept, to be sure, but it has revolutionized investing strategies and even contributed to economic theory.
What “invest in what you know” really means
The idea of investing in what you know is based on the premise that you, as a local consumer and expert, will have advanced knowledge of a product or process that investors who don’t use the product won’t have. For example, if you live in rural farming community and either buy or sell goods at a local farmer’s market, you may have insights into agricultural products that white-collar Wall Street bankers won’t.
Before you shrug off this advice as something only amateurs need or argue that it doesn’t follow the rules of diversification, let’s look at it from a different angle.
Let’s say you work as a sales manager in large corporation somewhere in Jackson, Mississippi and you’re looking for a new stock to buy. You look at a biotech company with rave reviews by analysts and great fundamentals so you buy it. A week later, it’s lost 50 percent of its value. What happened?
In this case, the company’s most promising new drug ran into trouble in obtaining approval from the U.S. Food and Drug Administration (FDA). Unless you’re a physician or pharmaceutical executive, the reasoning behind the stock’s decline might not have been apparent. If you’re not familiar with how the FDA approves drug trials or even what the drug does and how it’s made, you might not see any warning signs that the stock could be in trouble.
You can run into the same “intelligence blindspots” with any sector; technology, financials, and energy, for example. All have unique market factors that can make or break a stock’s performance.
If you don’t understand it, don’t invest
The advice “invest in what you know” might be better reversed. If you don’t understand what a company does or how it turns a profit, don’t invest.
On this blog we talk a lot about the importance of diversification: 90 percent of the time you’re going to make more money with a portfolio containing many dissimilar stocks and bonds as opposed to better on a few stocks that are “ready to take off”.
When you invest in mutual funds, for example, you get broad diversification (a good thing) but you also give up control of your investment choices. Most mutual funds will likely invest in some companies you’ve never even heard of, let alone understand. With an actively-managed mutual fund, that’s why you pay a fee each year to the fund’s manager — he or she is an investment professional paid to understand the companies the fund invests in.
But outside of mutual funds, you can still be diversified while “investing in what you know”.
You may not realize it, but you’re familiar with more companies than you realize. What kind of car do you drive? Ford? Chevy? How about your phone service? AT&T or Verizon perhaps? There are plenty of companies out there that you can invest in that don’t require a Ph.D. to understand.
Put another way: Can you explain why you bought a stock?
This investment strategy goes hand in hand with another one advocated by Jim Cramer: explaining your investments. Cramer’s litmus test for buying a stock is if somebody asks why you bought it, can you explain your decision?
This creates some accountability for your actions and helps you refine your choices. If you tell someone you bought XYZ stock because it looked cheap, it doesn’t hold as much weight as telling them you bought it because the company reported record earnings and upped next years’ guidance on higher sales expectations.
The Wall Street hype can easily overwhelm your better judgment and lead you to a poor investment choice, but taking a step back and remembering these simple rules could save you a lot or heartache and regret later on. Understanding what you own and why you own it sounds simple, but takes discipline to maintain.