When you’re just dipping your toes into the world of investing, a common suggestion is to “invest in what you know”. But that doesn’t make it good advice. In fact, invest in what you know is actually bad advice. Here’s why.
The intentions behind the suggestion to invest in what you know are good, because you absolutely don’t want to make investments that you don’t understand.
That’s because when you don’t understand get how a proposed investment is supposed to work, or even the things you’re investing in (mortgage-backed securities, anyone?), it’s easy to lose money or to be fleeced in some sort of scheme.
So it makes perfect sense (and indeed is good advice) to make sure that you understand the things you are investing in. You should also know how the investments should work, and what risks are involved. (Losing all of your money is always one of the risks, but you should know how likely that is based on what you’re considering investing in compared to other investments.)
When you stick with investing in what you know, by definition you only invest in things that you are familiar with. And most of us just don’t know a great deal of information about a huge variety of things. Naturally, that means that “what you know” is limited in scope.
Suppose you decide to buy some stocks, and you go with the standard advice about investing. That means you’ll invest in companies that you know something about or use regularly. Maybe Google, or the place where you work if they have an employee stock purchase plan. While those might happen to be excellent investments, having all of your eggs in just a few baskets is extremely risky. If all goes well, you’re in good shape. But if it doesn’t, you’re in deep trouble. Diversifying your investments is critical to spreading the risk.
Reverse the advice
It’s better to reverse the advice to get at the real meaning. So instead, make sure that you know what you’re investing in. Understand each investment — how it works, the potential for gain or loss, what industry it is in, and what that industry is doing. Of course, getting to know your potential investments takes time, and that’s why many people hire a professional to do their investing for them. But even if you hire a professional, you should still know and understand what you’re investing in. Don’t leave it all up to them, not worrying about it so long as you’re getting good returns. Know what you invest in, and you won’t be limited to the things you’re familiar with.
So reverse the advice. Learn, understand, and diversify, and your chances of making successful investments improve.Posted in Investing on 04.18.12 with 9 comments.