This is part of a larger article called The Golden Rules…
This principle actually covers two important concepts that became popular thanks to a pair of today’s greatest investing minds, Peter Lynch and Warren Buffett.
“Invest in what you know” – Peter Lynch
Remember Peter Lynch from the Mutual Fund Basics Guide? The guy who took over the $18Million dollar Magellan Fund in 1977 that grew to more than $14Billion in assets by the time he retired only thirteen years later in 1990. Peter advises beginners to “invest in what you know”, and his message still resonates with working people who don’t have the time to learn complicated technical analysis or read financial reports as thick as a phone book.
Invest in what you know. Sounds simple but there is a lot of wisdom in this advice. Lynch meant that in our everyday lives we tend to become experts in some field or another either because it relates to our career or because we use related products on a daily basis. For example, if you’ve been a pharmaceutical salesman for the past 15 years, you probably have picked up a lot of knowledge about the major companies, the industry, how a product is tested and marketed, not to mention detailed knowledge on any drugs that you have sold during your career. This expertise is your foundation and gold mine as an investor.
To emphasize this point, imagine the following example in which you are the pharmaceutical rep described above and you are trying to decide between two different investments.
The first is a profitable and established pharmaceutical company that you’ve been competing against for 15 years. Your friends think it’s a boring stock and point out that their share price hasn’t budged in five years while the market has made great gains. They tell you that new drugs come out all the time, and remind you that this company has already released two this year without making any impression on investors or impact to the share price.
However, you know that this pharmaceutical company has solid patents and recently received FDA approval for a cheaper generic version of a very expensive drug that your company makes. Sales for your company’s competing drug have plummeted as a result. You also know that this is a popular drug, many doctors will prescribe it to the elderly on a regular basis. You ask around different companies and reps in your industry and find that no one else has anything in testing or pending approval that can compete on a cost basis. Finally, this company is huge, they will have no trouble digging into their deep pockets to market and mass produce.
The second potential investment is a tech IPO that your broker and a couple of your friends are really excited about. Apparently they invented some type of technology that can improve the speed of all search engines and they just landed Google as a client, the major player in the search engine space. As a result of the Google deal, they are already making money which isn’t always the case for many startup tech companies. You’re seeing a lot of news about this IPO, it looks like it will be a hot stock since there’s already so much buzz. Your broker even offered to get you some IPO shares which will probably net you a nice profit on the very first day of trading.
What would Peter Lynch do? He would buy the pharmaceutical company every single time. Here’s what you know. The well-established pharmaceutical company has a new patent protected drug that is already approved for sale by the FDA. The tech company has an unproven product, investors don’t even know if major search engines such as their new client, Google, will need or continue to use the technology. The drug is already proving itself by outselling you, the competition. You have no idea how well the tech company is equipped to compete and it sounds like they may be dependent on their one major client for survival, Google. Not a strong position. Finally, there won’t be any competitors for several years for the drug company because no one is even testing a competing product yet. What are the barriers to entry for the tech company, could one pop up tomorrow or could Google or Yahoo just make their own version of the technology?
I don’t want you to get the impression that you should avoid every strategy, stock, or fund that you don’t know much about. What I’m trying to say is that you should play to your strengths when you invest. Invest in what you know when you can and when you want to try something new, take the time to learn a lot about it first.
Ignoring this rule can ruin even great strategies. For example, a value investor is always looking for great bargains, i.e. underpriced stocks. But if they buy companies that they know little about, more often than not they’ll wind up with a stock that has done something to deserve a low share price and would have been best avoided. There is an enormous amount of information available for any stock or fund that you’d like to buy. Study the company, their competition, their products, the industry, their historical performance, their earnings, the fund manager and anything else you can think of before you decide. This sounds like a lot of work but your portfolio will reward you generously in the form of profits if you do your homework.
“Keep it simple” – Warren Buffett
When Buffett tells individual investors to keep it simple he is most often encouraging them to become Index Investors. But isn’t he a Value Investor? Yes, but he is a value investor with an almost super-human knack for numbers, 30+ years experience, a lifelong passion for learning about investing, and he spends the majority of his waking hours studying the companies that he buys. I certainly don’t expect to ever develop that level of expertise and definitely don’t want to spend that much time studying my strategy. So, for an average joe like me, he’s actually giving wonderful advice.
Buffett is comfortable giving this advice because he knows that, if you want to encourage investors to keep it simple, Index Investing is a great strategy to recommend. It’s easier to learn and lower maintenance than most, so new investors can master and maintain the strategy much more quickly than more demanding strategies such as Value Investing or Growth Investing. Index Investing is also the most cost- and tax-efficient strategy you’ll find since you buy-and-hold-and-hold-and-hold. Most important, this strategy allows the average investor to compete with anyone, Index Investors beat over 75% of all professional fund managers and analysts.
Sorry about the tangent, I get excited whenever I get the opportunity to talk about Index Investing, it’s a great strategy for any investor (not just beginners). If you’d like to learn more about Index Investing, Index Funds or ETFs, I’ve written a couple of related posts. Read this Index Investing Strategy Review if you want a brief introduction or, if you’re feeling really ambitious, read my Complete Guide to Index Investing.
Back to the point, Keep it simple… this is so true about everything in life and it’s especially true about investing. As a beginner, you are probably overwhelmed by the amount of information you need to learn to become a savvy investor. This is a good time to point out an important fact. Your confusion is a result of your lack of knowledge and from the overwhelming amount of new information I’m throwing at you, NOT because investing is complex and sophisticated.
Don’t stray from the keep it simple philosophy as you become a more seasoned investor. Einstein said that “everything should be made as simple as possible, but no simpler” and that’s great advice. You have to understand the basics of your strategy, but don’t needlessly add complexity because you feel being a more sophisticated investor will make you more successful.
Best of luck and please add your thoughts to this post, we’ll all benefit from your questions and insights.
Back to main article, The Golden Rules…