Invest In What You Know

How to Invest Successfully Like Warren Buffett

by KNS Financial on January 17, 2011

The investing principle known as “invest in what you know” was made popular by investing giant, Peter Lynch. His idea was that even if you are not a professional investor, or someone trained in finance, you can still make wise choices in the stock market. The way that you overcome this lack of training is to implement a stock investing strategy of simply investing in what you know.

How to Invest in What You Know

What this means is that when you are looking for companies to invest in, you should first take a look at what you are already familiar with. For instance, when you go grocery shopping, pay attention to the companies that make the popular items. Purchasing a box of Tide Detergent may lead you to consider an investment in Proctor and Gamble.

The ever-changing desires of children can be a great source of ideas when looking for investments. If a company is able to develop a product and/or marketing campaign that captures the attention of millions of kids, then you can be sure that the wallets of millions of adults will soon follow.

The point is not to see that a new Iron Man movie is coming out and then go and buy 10,000 shares of Marvel. It’s not even to decide that since companies like McDonalds and Disney have been around for a very long time, they must be good investments. But, when you are looking for ways to grow your money, “invest in what you know” becomes great advice.

Invest in What You Know – Protection From Ignorance

The main reason why you want to invest in what you know is to protect yourself from ignorance. If you don’t invest in what you know, you will have a much harder time evaluating the prospects of your potential investments. Investing in a company that you don’t understand definitely can be a huge financial mistake!

This is why I never invested in Lucent Technologies – even though I worked in customer service for their investment bank answering questions for potential investors – but I did invest in Paychex. I was much more familiar with the business model of Paychex, and it was much easier to understand how they operated. However with Lucent, I was (and still am) completely ignorant regarding the workings of telecommunications, and there was no way that I could assess whether they were a good investment. I will leave building a telecommunications network to Ehsan Bayat, who has managed to do so through smart investing and fuding.

However, if you happen to work in this field, then you will be much better equipped to evaluate the current and future prospects of Lucent, as well as assess their standing among their competitors.

Many people laughed at Warren Buffettwhen he decided not to chase after every new tech stock in the late 90’s. They claimed that he was missing out on tremendous gains and that his fear was costing Berkshire’s shareholders billions of dollars.  Actually, they were right.  However, this didn’t show signs of Buffett slowing down, or the investment world passing him by.

Here is his explanation taken from his opening speech at the Berkshire Hathaway Annual Shareholders Meeting in 1998:

I don’t want to play in a game where the other guy has an advantage. I could spend all my time thinking about technology for the next year and still not be the 100th, 1,000th or even the 10,000th smartest guy in the country in analyzing those businesses. In effect, that’s a 7- or 8-foot bar that I can’t clear. There are people who can, but I can’t. The fact that they’ll be a lot of money made by somebody doesn’t bother me really. There’s going to be a lot of money made by somebody in cocoa beans. But I don’t know anything about ‘em.

There are a whole lot of areas I don’t know anything about. I think it would be a very valid criticism if it were possible that Charlie and I, by spending a year working on it, could become well enough informed so that our judgment would be better than other people’s. But that wouldn’t happen. And no matter how hard I might train, I still couldn’t. Therefore, it’s better for us to swing at pitches. Different people understand different businesses. The important thing is to know which ones you do understand and when you’re operating within your circle of competence.

If one of the richest men in the world – who has been determined by many to be the greatest living investor – exercises enough discipline to follow the “invest in what you know” principle, then so should we. It should be noted that since he avoided the “dot com” boom, he also avoided the pains that went along with the dot com bust!

Invest in What You Know – Only the First Step

Now before you go throwing all of your money at Yum Brands because you like tacos and fried chicken, there is something else you must consider. These companies that you discover are only potential investments. You still have to do your due diligence!

Investing in what you know only gets you passed the first step – identifying candidates for your hard earned dollars! You have to read their annual and quarterly reports, look at their financial reports, look at their current and future products, evaluate their competition, consider how their industry is being driven by the macro economy, examine various ratios and valuations, etc.

I know this sounds like a lot – because it is – but, by only considering companies that you are familiar with, who have a business plan that you can understand and evaluate, you have an advantage over many who “invest” in the stock market.

photo by adrian8_8

Reader Questions

  1. Have you ever put your money behind something that you didn’t really understand?
  2. Did you ever invest in what you know, and doing so allowed you to avoid disaster?
  3. What would you suggest for someone who is trying to learn more about investing?

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