Why “Invest in What You Know” is Bad Advice
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.
Good intentions
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.)
Risky results
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.
Another risk of “invest in what you know” is that you get emotionally attached to what you know. And we all know that emotions and investing and not a perfect couple. Yes, “know what you invest in” is very true. And know it is business, not personal.
That’s a good point too; we do get emotionally attached to the things we know (and own).
Great post! I agree that the answer is to be more educated in a possible investment. A lot of people aren’t interested, though, in the research time for something so important.
You’re right, many people aren’t interested in doing the research or taking the time to learn about their investments. Which is sad, since I’m sure they ARE interested in making money…
I usually start with companies/brands that I know, then do the research. If their terrible investments I move on. Plus, it keeps me from investing in companies I have no clue about, like biotech, I don’t get chemistry or the FDA approval process.
How do you make sure you have a diversified portfolio then though?
The number of products and brands we’re exposed to daily is immense. Most of the time we tune it out though. There’s all the food and drink brands, car brands, the electric, gas, phone, and cable companies, computer/smartphone brands, clothing brands, shoe brands, online stores and the delivery services they use, health products, medication, cigarettes, gambling, movies and tv shows, all the stores we buy the brands from, and how we pay for them. Then there are the companies we’re exposed to through work.
Some companies will be public, others private. I can cross off the companies I don’t understand and aren’t worth investing in. The companies I do understand have competitors I can research too. I’m positive the list is incomplete. But it’s a good start.
Investing in what you know per se is not a bad strategy. I think as long as you don’t fall in love with a stock you are ok. Remember it’s just a vehicle to make money it’s not your kids or your family. You can dump them anytime you want.
I also think when people are in a particular industry they think they “know it” so they get a false sense of security that they know everything about their industry. You can know everything about an industry and just invest at the wrong time.
Dan
Well, it’s not a bad strategy if you expand your knowledge and make sure you’re diversified, but I’m not sure how many people do that.