Peter Lynch became a famous investment guru by arguing that we should all, “Buy what you know.” This sentiment is now routinely espoused by financial magazines and blogs who struggle to come up with daily content that the average person will understand. The problem is that this doesn’t really work and it’s actually pretty likely to negatively influence investors as they overestimate the importance of their daily preferences in their day to day experience.
Buffett Knows (© t-shirt idea)
I’m a much bigger proponent of Warren Buffett’s approach which is to buy what you understand. The thing is that guys like Lynch and Buffett both know and understand so much more than the average retail investor does, that applying their strategies is nearly impossible for most of us. When Lynch sees a product, he is able to internalize its appeal to him as a consumer, alongside heaps of information he has already has on production costs, management status, international considerations, sector competition, patent laws, and thousands of other variables that would never cross most peoples’ minds when they say, “Hey everyone loves Beanie Babies today, I bet that company is going to make tons of money in a few years.”
Your Instincts Probably Suck
Just because you see a lot of people around you wearing clothing with some preppy brand name proudly displayed (you know, the kind of stuff that says, “I badly need this status symbol to show that I am upper-middle class no matter how douchey it makes me look to others”) doesn’t mean that the company is a good investment. In fact, it has almost no relevance to whether it is a good investment at all. Most individuals only interact with other people who much like them in terms of values and socio-economic status. This means that your observations – or what you “know” – is inherently bias and flawed in terms of drawing conclusions from a sample that isn’t even close to representative. There are all kinds of psychological reasons for this – check out the book Sway for more details.
“Golf Is a Good Walk Ruined” – Mark Twain
On the flip side of this argument we have one of my favorite investing bloggers to read – JT McGee from Money Mamba. Sometimes this guy almost succeeds in bringing me over to the dark side of active management – then I realize I’m not as smart nor as committed as he is and hug my low-cost index ETFs close to my chest. JT’s self-described best move was purchasing Adam’s Golf a couple years before the company was purchased be Adidas. He made a massive profit on the deal and he certainly didn’t chalk it up to knowing about golf. He didn’t go to his local course and talk to his country club friends about the fact that everyone was using Adam’s Golf equipment (because they weren’t, it was a relatively small company when compared to giants such as Adidas’ TaylorMade and Calloway). JT made the deal because he understood the business behind the product. At the end of the day, it really doesn’t matter how good the Adam’s Golf product is – it only matters if they sold enough product to be extremely profitable and an enticing takeover target.
Numbers Matter More Than What You Think You Know
The phrase “buy what you know” is completely taken out of context by most “financial gurus”. What Lynch and Buffett know it great detail (which allows them to understand) is how to evaluate company fundamentals. Now I certainly don’t claim to be an Oracle, or even a Money Mamba, but I have picked up enough to know that just because a company is popular, or has been great in the past, doesn’t mean it is a good investment. This completely ignores the reality of looking at a stock price (basically the price of the company) as compared to how much money the company might reasonably make in the future. This is where things like price-to-earnings (P/E) ratios, balance sheets, cash flow projections, moats, sector outlooks, and management turnover come into play. If you aren’t completely comfortable with these metrics and what they mean, they you don’t really know what you’re buying.
“I Know One Thing – That I Know Nothing” – Socrates
This sort of overestimation of our own abilities to “pick winners” based on the sensory input of the environment around us on a daily basis is likely one of the biggest reasons why people who pick their own stocks do so much worse than index investors. A recent study by Morningstar stated that the average stock investor trailed the average returns generated by the stock market from 24% from 2001-2011. This study is not an anomaly. A Dalbar study from 1990-2010 showed that while the S&P 500 had an average return of 9.1% for the twenty year period, the average American stock investor achieved a 3.8% return. I’m sure lots of these investors figured they “knew” what they purchasing as well.
Unless you’re willing to put in the time to truly understand the investments you’re making, you’re almost assuredly better off staying out of them altogether. Statistics would argue most investors don’t even understand how much they don’t know – and that degree of folly can be pretty destructive when mixed the overconfidence born of reading to many space-filler articles from investment publications whose livelihood depends upon active trading strategies amongst retail investors