Why “investing in What You Know” Doesn’t Always Work
There is an old financial adage that you have to invest in what you know. This sounds like decent enough advice, but there are several reasons it can backfire.
Many investors have talked about this, but this quote is usually attributed to Peter Lynch of Fidelity. And while you should have a basic understanding of how investing works, many people understand that this advice means “only invest in the industries you are familiar with.” But one financial advisor told Bankrate how this could backfire:
“We’ve seen clients in certain industries, such as healthcare, have a portfolio full of healthcare stocks,” says Antenucci. “They are fascinated by these companies because they are familiar with them. These clients receive a portfolio with a higher level of risk than a diversified portfolio of stocks and bonds from different sectors and countries. ”
Lack of diversification can make it difficult to cope with an industry downturn.
“If your job is in the healthcare sector and the healthcare industry as a whole is under pressure, then there is an additional risk that your investment portfolio could also shrink at a time when you could lose your job,” says Antenucci.
If “what you know” means having a diversified portfolio of index funds that reflects the broader market , that is one thing. But just because you are in an industry and are familiar with it does not mean that you can predict specific market fluctuations.
Carl Richards, financial advisor and New York Times writer, further explains that a common understanding of this rule betrays its original context. It is assumed that this is about learning and not about choosing stocks based on limited knowledge. Richards explains :
People use it to justify risky investment decisions …
And it’s not just Mr. Lynch being taken out of context. Warren Buffett gave similar advice on how to never invest in a business that you don’t understand.
But here’s what we need to remember: whatever the advice is, it is only the starting point for investors like Mr. Lynch and Mr. Buffett, not the end point. Yes, they may have started with what they knew. But they also did a lot of research, and this second part is missing in the decision-making process of many investors … I’ve heard that more than one person justifies the decision to buy Apple stock because they really like their iPhone. It’s about as smart as buying Crumbs stock because you love their cupcakes.
In short, the advice has never been about manually picking stocks based on an industry you’re new to. And in any case, it is better to invest in the long term with a buy and hold portfolio . It’s not that exciting, but it works.
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