Invest Beyond What You Know
Many DIY investors feel most comfortable investing in companies that they understand, such as those within their own field of expertise. Research shows that this is not always the best strategy.Have you ever tried your hand at creative writing? I haven’t done much of it, but I know that one of the first things you hear on the subject is to “write what you know.” Unfortunately, if I just write about what I know, it usually isn’t all that interesting!
Let’s face it, most of our lives are not as exciting as the lives of characters in great literature and films. There may be a few folks out there who really want to read about a financial advisor who goes to work, makes some investment decisions, then picks up her kids, tries to get them to sleep, and triumphantly makes one cold margarita for herself before bed. But I’m not convinced that would be a best seller.
This is the problem with cliched wisdom. It often leaves out a very important condition that is necessary for it to ring true.“Write what you know” is great advice… IF you have lived a really interesting life or know a lot about truly extraordinary things! Maya Angelou was wise to write about what she knew. She grew up in the South under segregation and was separated from her mother as a young child. I Know Why The Caged Bird Sings is a beautiful, poignant account of her childhood. Leo Tolstoy served as an artillery officer in the Crimean War. This gruesome experience transformed him from a casual patriot to a committed pacifist, and established the belief system and knowledge base that helped him write his first novel, War and Peace. With a life like that, writing about what you know is a great idea!
A similar concept is found in the investing world.The legendary fund manager Peter Lynch was known for his outstanding performance as head of Fidelity's Magellan Fund. "Invest in what you know," was one of his favorite investment tenets.But some research has found that investing in what you know best isn't such a great idea. One study looked at 10 years of stock transaction data and compared that to the jobs held by the investors. The expectation was that individuals’ investments related to their profession should outperform the market because of better access to information, and a superior ability to process that information. But that’s not what the study found.The study found those work-related investments underperformed over time.
People invested in what they were comfortable with -- but that wasn't the best investment strategy. In fact, investors' overconfidence in a single sector often resulted in added risk.Successful real estate brokers with large personal real estate holdings were in a world of hurt during the 2007-2008 housing collapse. If you were a tech-savvy software developer who predominantly invested in the internet's ground floor, your portfolio was probably devastated during the 1999 dot.com bust.Even if there isn't a cataclysmic crisis, almost all economic sectors go through cycles, whether it's energy, transportation, entertainment or retail. And as an investor, you can minimize the fallout in any one sector by holding a broader range of stocks -- especially those outside your own professional niche.
So maybe the phrase, “Invest in what you know,” is good advice… IF you are a legendary fund manager who spent a lifetime developing deep expertise in many sectors of the economy.If not, you might be better off sticking with unconditional investing clichés, like, “stay diversified.” And if you don’t know how, ETFs are an easy way to get started.