Let's say you stumble across a stock you've never heard of before that has generated amazing annual returns of 20% or more year after year. Would you immediately add it to your portfolio? If you're smart, you'd answer no. What if Warren Buffett recommended it? Your answer should still be no.
The reasoning is simple: If you've never heard of the company before, you probably don't have any idea how it makes its money. You might be thinking, "Big deal. Look at those returns!" But I promise you, it is a big deal, and below, we'll look at why.
Why you need to know how a company makes its money
When you purchase a stock, you're investing in a company and betting on its future success. But if you don't know how it makes its money, you won't be able to tell when it's headed for a fall.
Understanding a company's business model can help you better predict how its leadership's decisions and industry trends could affect the company's stock price. For example, let's say in a bizarre parallel universe, Netflix (NFLX -0.31%) decides to go back to its old way of doing things, foregoing the streaming service we've all come to know and love and instead shipping old-fashioned DVDs to your door.
As someone who presumably understands how Netflix works and why it's so successful, you would be able to tell that that move is going to be bad for business and that Netflix's stock price is probably going to drop. But if you had never heard of Netflix and weren't able to guess what it does from the company name, you might not realize its leaders have just made a terrible mistake. If you buy its stock just to hop on the bandwagon with everyone else, you could find yourself facing huge losses in this scenario.
Understanding how a company makes its money can also help you identify when it's doing well and when it might be time to buy even more of its stock. If Apple releases the iPhone 13 later this year to rave reviews, that could clue you in to the fact that the company is doing a great job at producing products people want -- and that could be a good time to invest more in its stock.
How to choose the best stocks for you
Investing only in companies you know well is what Warren Buffett refers to as investing in your "circle of competence." If you're new to investing, you may not think that's very large, but it's probably bigger than you think. You don't need to understand every business decision a company has ever made. You just need to have a general idea of how it makes money.
If you've ever used Netflix -- or even if you're just familiar with what it does -- that falls into your circle of competence. Same goes for the manufacturers of the groceries and household items you buy every day. You probably also know how airlines, auto makers, and retail stores make their money, so they're potentially good investments for you too.
Your job might also open up more companies you can add to your circle of competence. For example, if you work in the tech industry, you might know about some more obscure tech stocks that an outsider may not be familiar with. These are all good places to start when deciding what you'd like to invest in.
What if I want to invest in a company I don't understand?
To return to our fictional company stock with the 20% annual returns, let's say you're interested in possibly investing in it but you're not familiar with what the company does. That doesn't mean you can't add it to your portfolio. It just means you shouldn't do so right away.
You need to do your research first to familiarize yourself with how the company operates, why it's been so successful to date, and whether its stock has the potential to continue providing these outstanding returns in years to come.
There's no magic stat that can tell you whether a company's worth investing in. There are many factors to consider, including a stock's price-to-earnings (P/E) ratio, its debt-to-earnings ratio, its management team, and industry trends. As you become a more experienced investor, you'll learn how all these factors play into one another and how to identify the truly valuable stocks from the ones that aren't worth the hype.