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Don’t Invest In What You Know

Posted By Jim On 08/21/2008 @ 6:15 am In Devil's Advocate | 7 Comments

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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