Warren Buffett has famously said, invest in what you know. This line of thinking is what many have attributed to his foresightful decision to stay out of the internet bubble in the late 1990’s.
Likewise, Peter Lynch is known for having an almost identical mindset. He says, “The best way to invest is to look at companies competing in the field where you work.”
What does it mean to invest in what you know, and is this popular-wisdom good advice for individual investors?
– This article appeared first on The Stock Market Blueprint Blog.
Invest in What You Know
According to Buffett, an investor must understand a company’s products and its business model before making an investment. He calls this level of understanding a “circle of competence.”
Peter Lynch says you must have a “specialized knowledge” of a company and its industry to “know” a stock. He says, “Someone with deep restaurant-industry experience would have predicted the success of Panera Bread Co (NASDAQ:PNRA) and Chipotle Mexican Grill, Inc. (NYSE:CMG). If you’re in the steel industry and it ever turns around, you’ll see it before I do.”
There’s no denying that Warren Buffett and Peter Lynch are among the most successful investors of all-time. However, their advice to invest in what you know is not only impractical for individual investors, it’s also dangerous. Small investors who follow this advice will inevitably lose patience and throw in the towel.
Investors do not need to like, understand, or even be familiar with a company and its products before buying its stock. In fact, they should try to avoid making investment decisions based on this type of qualitative information.
Why is it so dangerous to invest in what you know? In addition to being impractical, investing in companies you’re familiar with limits your options and causes overconfidence in your decisions.
Here’s an overview of why you should not invest in what you know.
To know a company is to deeply understand the inner workings of the business; including but not limited to its managers, employees, customers, suppliers, competitors, etc.
According to a write-up in AAII Journal, Peter Lynch believes investors should thoroughly familiarize themselves with a company in order to “form reasonable expectations concerning the future.” AAII goes on to say, “[Lynch] suggests that you examine the company’s plans – how does it intend to increase its earnings, and how are those intentions actually being fulfilled?”
The obvious question is: how familiar should an investor be with a company before purchasing its stock?
Warren Buffett provided his opinion during a 1998 lecture at the University of Florida (1):
“Now I did a lot of work in the earlier years just getting familiar with businesses and the way I would do that is use what Phil Fisher would call, the “Scuttlebutt Approach.” I would go out and talk to customers, suppliers, and maybe ex-employees in some cases. Everybody. Every time I was interested in an industry, say it was coal, I would go around and see every coal company. I would ask every CEO, ‘If you could only buy stock in one coal company that was not your own, which one would it be and why?’ You piece those things together, you learn about the business after a while.”
Buffett literally talked to everybody before buying a stock: customers, suppliers, employees, competitors, and CEOs. If that’s not impractical for a small investor, then what is?
It’s dangerous to only invest in companies you like, understand, or are familiar with. Doing so will inevitably cause investors to be too optimistic about a company’s prospects. Thus, leading to buying at the wrong time and overpaying for a stock.