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Don’t Invest In What You Know

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This is a Devil's Advocate post.

One of Peter Lynch’s most famed principles of investing is “Invest in what you know.”

I humbly disagree.

You Don’t Actually Know

The only problem with that bit of advice is that, as human beings, we tend to have too high an opinion of our own intelligence and abilities. In other words, you think you “know” but you probably don’t actually know as much as you think you do, or as well as you think you do.

I was studying computer science at Carnegie Mellon University during the tech boom of the late nineties and (very) early 2000s. I saw all these technology companies offering great services and saw that there was a very bright future in technology. I saw that the future of commerce was online so I believed that companies like Amazon.com and Buy.com and Overstock.com would be the future powerhouses (none have reached they tech bubble peaks, but all are doing relatively well… though Overstock’s CEO keeps complaining about the shorts). The only problem is that while I knew basic computer science theories, I didn’t actually know much about technology companies and the business world. I thought I knew, but I didn’t.

Too Many Eggs In One Basket

Another reason this bit of advice is dangerous is because it depends localized knowledge and, more specifically, often knowledge of an industry you’re working in. That’s dangerous for the very same reasons why people often recommend that you don’t invest your 401(k) money in company stock. When you invest your 401(k) in your own company, you run the risk of being hit with a double whammy if a market downturn affects your company. You don’t want your long term retirement assets pegged to your job, right? While the reverse may still hold true, if things go well then they go doubly well for you, it’s a risk that simply isn’t worth it in the opinion of most financial advisers.

Diversify Everywhere

Let’s say that you really do know an industry inside and out, that’s still only one industry. While Lynch’s advice wasn’t that you should put 100% of your investments into any one thing, it could be misunderstood. If you’re supposed to invest in what you know, shouldn’t you invest it all in at least that industry? Or that one country? I live in the United States, I “know” the United States, does that mean I should invest in domestic markets only? Probably not.

Even Those Who Know, Don’t

In reading Full of Bull, I saw how weak industry analysts were at predicting the trends in the industries they were covering. They spend their entire days analyzing industries, far more than what you would do if you worked in that industry, yet they were unable to pick the winners from the losers with any consistency. While part of the reason was because they had to play the marketing game, the reality is that the market is more of a random walk than an orderly march. Even those who devote their entire careers to tracking specific industries aren’t good at picking the winners.

I know I took a good statement and twisted every which way but I think it’s valid. Don’t invest with what you know, invest in fund who are led by people who know a lot and who invest in a lot of things. Or buy an index fund. :)

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7 Responses to “Don’t Invest In What You Know”

  1. You make an excellent point and I will add that, while it is true that “knowledge is power,” knowledge is certainly not wisdom.

    Wisdom, in my humble opinion, is “knowing what you don’t know” or awareness of your own ignorance, which is a human condition shared by everyone — including fund managers.

    Your final statement says, “Don’t invest with what you know, invest in fund who are led by people who know a lot and who invest in a lot of things. Or buy an index fund.”

    While this guidance is good, it would be better (for the average investor) to use only index funds. Investing in a fund that is “led by people who know a lot” does not resolve the problem at hand — it only buys the investor a basket of stocks or bonds managed by a person or a team that is just as susceptible to human error as anyone else, which is why the majority of fund managers do not beat the indexes over long periods of time…

    Thanks for the interesting perspective…

    Kent @ The Financial Philosopher

  2. Start-Up says:

    I agree with Kent, that last statement is rather ridiculous. How are you supposed to know which funds are led by people who know a lot? From my readings it seems as though picking mutual fund managers is just as much of a random walk as the stock market. The idea of buying an index fund is probably the best thing you can do, as long as you KEEP THE COSTS DOWN.

    Invest in what you know. I take that to mean, if you are knowlegdeable in pharmaceuticals, then stick to pharmaceuticals when selecting individual stocks. I think Lynch meant his advice to be used when selecting individual stocks, which can be super fun, but make sure it is only a portion of your overall nest egg, especially if you only have expertise in one area.

    Thanks for the devil’s advocate point of view, always seems to make me want to comment.

  3. The problem with “knowledge” and the markets is that the price of equities already takes into account what people “know”. But future movement is based on what we cannot know (unless you are an insider). So forget managed funds – the knowledge of the fund managers doesn’t really help. Index funds + proper allocation is what you need to know to survive.

  4. Matt says:

    I realize this is a devil’s advocate post, but I must humbly disagree w/ the “don’t invest in what you don’t know” thesis. I’m a biochemist by education and investing in the pharma & biotech sector has made me a double the profits I’ve made in my “not in the know” portfolio over the last 10 years. Now, before you go into the being overweight and diversification argument, I fully admit to being overweight in this sector but I’ve also learned to TRADE these overweight sectors by putting protective stops in place.

    As to the statement in your opening scenario regarding being overweight in tech – I wholeheartedly agree that it was certainly a bubble and you potentially got hammered like many others. However, the simple fact remains that bubbles create trading markets, and you likely made investments in companies that shot up 100% or more in less than year. It’s only natural that momentum stocks would fall, and fall they certainly did.

    Traders such as myself later took that opportunity to short everything tech related from 2001 to 2003. Point is – you can’t be an investor in companies that CNBC hypes everyday (think Amazon.com or JDS Uniphase from 2000) and expect them to stay above the stratosphere forever. Same thing is happening in the oil markets today in 2008.

  5. While I agree with you on the one hand (as someone who has been in the brokerage industry for 15 years), I think telling people who are already unsure about investing to try to disregard what knowledge they do have just adds another layer of anxiety.

    But yeah, index funds kinda take care of all of that. I’ll be posting something about mutual fund expenses tomorrow, actually, and it basically concludes with, “or you could just get an index fund.”

  6. CarlosPorto says:

    Hey Jim, just came across this post and wanted to chip in with my two cents. I agree that basing any kind of investment strategy on simply “investing in what you know” is a bad idea. However, I totally agree with Andrea too. It can be a great introduction to the market. Maybe not to find specific stock picks, but to learn.

    Say you want to learn about valuation or reading financial statements. Would you rather read the annual report for Apple or for some random banking stock? It’ll be a lot easier to start with the companies you care about/know about to learn this stuff.

  7. DERPADERP says:

    I’m laughing hard right now considering Peter Lynch’s net worth is $352 million.

    I’ve never even heard of you.

    So I, E. Lynch (Yes, I’m a relative of Peter), Humbly disagree with YOU.

    To each their own I suppose…

    Good Day Sir.


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