InvestorGeeks

The Importance of Buying What You Know

by Chris

Frank, Jason and I were having dinner this past Saturday and we were discussing future markets. Jason brought up Biotech and was talking about some of the possibilities for future advances, and how they may affect the industry. Now, Biotech is something I know very little about — in fact, I know almost nothing about it. As a result I probably am not going to invest in Biotech in the near future.

One of the things a savvy investor must do is understand his own strengths. In the words of Sun Tzu, “Know your enemy, know yourself.” In many cases, you are your own worst enemy. When looking for new investments in either stocks or bonds or any other type of security, you should have a high level confidence in what you are investing in. Each investment has its own risks and challenges and fully understanding them will prepare you in case of unexpected events. For example, factors affecting bonds include changing interest rates, yields, and term; for stocks gaining a basic understanding of how the company functions and how it is performing internally is required background research.

When faced with the option to purchase stock from a company whose industry is abstract and foreign to you, it may be worth passing it up. As an illustration, I work in technology, and as a result I stay relatively up to speed on current events in technology and technology related companies. I’m also in a technical position so I understand the technology behind the news. That makes it relatively easy for me to sniff out hype from real growth. However, I never hear anything about copper mines, who buys copper or even who makes copper. As a result, I would need to read up on the natural resources industry, and pass up on investments in that industry until I do.

And don’t be so trusting of everything you read because hype comes from everywhere. I often see articles about tech companies in SmartMoney that are full of more hot air than real substance. This is not to say that the writers at SmartMoney are devious and should not be trusted. Companies have trained marketing staffs waiting for the ear of financial reporters and pundits. A little salesmanship on the part of the company, and a little excitement on the part of the writer, and puffed up articles are never far behind. Writers are not to blame, these things happen to all of us; all it means is that writers are humans too and we need to do our own homework before making an investment decision.

There are many, many companies out there in many different industries. In fact, the market is divided into 12 large groups called “sectors.” These range from terms like “Financial” to “Consumer/Non-cyclical.” Inside these sectors are “industries” such as “Investment Services” and “Personal & Household Products.” With all these choices, it is best to stick with industries and sectors that you have frequent interaction with, or that you understand on a deep level.

Some examples of suitable industries for you may encounter every day include Restaurants, Grocery Stores, Consumer Goods, Entertainment. In addition, your job or hobbies may place you in contact with additional industries which should be added to the list. By sticking with what you know, you’ll be able to spot hidden traps while you’re analyzing a possible new investment, potentially saving you from heavy loses or underperformance.