It is bad, and it happens every day, all around the world. Not tawdry clandestine flirtations, but the purchasing of an investment without an understanding of the investment.
You've probably done it, or considered doing it. You received a phone call from an high-pressure stock broker. You received a hot tip that "can't miss" from a friend who has a history of tips. You received an e-mail promising riches if you just buy a penny stock.
And you considered it. Your mind pondered: What if? Maybe this one will really prove out. Maybe I should do it. Maybe.
Millions do it every year. They buy something they don't understand. A stock. A mutual fund. A real estate investment. And most of these investors get burned. Badly.
It isn't that you can't grow wealth by investing in such vehicles. Obviously you can. It's just that in most all cases, you need to understand what you're getting into -- study and truly understand it and why it should work out -- if you're going to have consistent success. Because if you can't understand and explain in simple terms why an investment should work out, it almost certainly will not.
If you're just buying something because someone told you that it will make you wealthy, you're stepping directly into folly. Nobody has a golden tongue. Nobody is so brilliant that they can share their best ideas and make everyone else rich. Consider full-service brokers purporting to have great ideas. If their investing ideas are so brilliant, why do they need to charge annual fees every which way from Sunday?
Understand what you own
I'll propose a simple equation:
Your Level of Understanding = Your Long-Term Investment Performance
The two sides of this equation rise and fall together. The greater your understanding of your investments, the greater your long-term investment performance is likely to be. I believe that this will prove true whether you choose to invest in real estate, stocks, bonds, ostrich farms, and so forth.
There are many reasons for this equation working. The greatest reason is this: If you don't buy anything until you have a skilled understanding of it, you're going to sidestep 95% of the bonehead mistakes that you'd make when buying investments without doing your homework beforehand.
Another reason: When you invest in something that you understand and are comfortable owning, you are much more likely to be comfortable riding out the inevitable hard times. Contrariwise, when you own an investment that makes you nervous for lack of understanding, you're much more likely to freak and sell it whenever the wind blows sour.
Don't follow the crowd, follow your mind
In May of 1999, the Fool's Boring Portfolio sold its shares of Cisco Systems (Nasdaq: CSCO) because Dale Wettlaufer, the portfolio's manager, couldn't see the value proposition behind the soaring stock or determine the long-term potential and competitive landscape of the technology. The sell report was well explained. However, he received flak for selling such a darling stock, one loved by thousands. That Cisco has fallen significantly since then is not material. That Dale hasn't suffered that fall while holding something that he didn't understand in the first place is.
Enron (NYSE: ENE) had plenty of buzz. The energy-trading company was worth more than $60 billion at its peak. Many readers wanted Drip Port to buy it. We looked at it, but we couldn't get comfortable with the business. Now it may be worth $0. How many investors bought Enron because it had an exciting aura surrounding it, but didn't do their homework to truly understand it? I bet hundreds, if not thousands, including hundreds of mutual funds. Many more piled into Lucent (NYSE: LU) for similarly suspect reasons ("it's popular!"), while lacking an understanding of the business.
We take at least several months to reach each buy decision for a reason: We must understand what we're buying and we must be comfortable with all aspects of ownership. Everyone understands different things. Warren Buffett understands insurance, candy and furniture retail, and similar businesses. His success is attributable to his not going outside of what he understands or is comfortable owning. Period. (Almost. He's also a smart, humble guy.) By buying only what he understands, he can buy at good prices and earn a strong return.