Buy what you know. None other than the illustrious Warren Buffett and Peter Lynch have proffered their endorsement of this investing principle. So why am I challenging the advice of two such well-respected professional investors? Because I believe the underlying message has been garbled -- lost in translation, as it were.
There's much more to investing than simply sticking to what you know. What's more, sometimes you may find that you don't know what you think you know, and other times you may realize that you know more than you think. In any case, let's dig a bit deeper into this matter.
Know your limits
The trouble with some investors sticking to "buy what you know" (BWYK) is that they don't quite appreciate what they know and what they don't know. For all the greatness the human mind is capable of, it does have its pitfalls.
For instance, we humans often confuse randomness for patterns, assume our tastes and views are the norm, and sometimes even convince ourselves we're seeing things that aren't really there (or, conversely, not seeing things that actually are there if we don't want to see them).
Our brains aren't usually geared for statistical thinking. Most of us walk through our local shopping malls and automatically think that the busiest stores we see must always be busy and that the empty stores must always be empty -- even though it could just be an anomaly for that day, that store, or that community.
We also sometimes tend to extrapolate too much from personal experience. For instance, every time I write about Motley Fool Stock Advisor pick Best Buy (NYSE:BBY), some readers feel the need to write me and tell me how much they hate their local Best Buy store and how wrong I am to like the company. Well, maybe their experiences have been unpleasant, but we're talking about a national chain that's still growing -- in other words, people en masse are voting with their wallets, and Best Buy is still winning.
People also slip into the mistake of assuming that they represent the average person -- that their likes and dislikes are the same as those of people on a larger scale. For example, I've never thought that the food at Outback Steakhouse (NYSE:OSI) was anything special. Yet this is one of the best-run restaurant concepts around, and there are hundreds of thousands of people who love its restaurants. My bias has left me on the sidelines of a great growth story.
People are also more than capable of convincing themselves that they actually see whatever it is they want to see. How many people have seen religious images in water stains, grease spots, or food? It's no different with stocks. Once some people convince themselves that a certain stock is a "can't miss," they no longer invest in what they know but rather in what they believe. All news is thereafter filtered through that positive bias, and information that contradicts the belief is attacked or ignored.
The limits of real life
There are also many cases in which an individual investor just can't get any practical firsthand experience before investing. For instance, small regional banks have often been great investments, but how is someone living in Bakersfield, Calif., going to "know" a bank in Arkansas, or vice versa? That's even true of a large company like General Electric (NYSE:GE). I may think I know about the quality of GE appliances and light bulbs, but I don't know a thing about its locomotive, gas turbine, or nuclear businesses.
So here is where I begin to redefine what BWYK means. I might not have firsthand knowledge or experience with a regional bank in Washington state, but I have invested successfully in regional banks before, and I believe I know what to look for in other banks. Likewise, I can't possibly know or understand every aspect of a company like General Electric, but I can know the company's history and make an educated judgment on whether its current price and prospects seem good enough to warrant an investment.
You can always learn more
I think one notion that is often overlooked in BWYK is the idea that you can continue to learn as long as you're willing to do some work. I wouldn't presume that Peter Lynch knew well all of the hundreds (if not thousands) of stocks he owned in his career, but I do believe he worked tirelessly to always broaden his knowledge base and learn new things. And remember, he didn't have the advantage of the Internet for his mutual fund career.
It is possible to learn. I've never worked in the railroad or energy industries, but I've been able to teach myself enough to make several successful investments in both sectors. Ditto with technology -- I'm not a computer expert or engineer, but I learned enough to hold successful positions in stocks like EMC and IBM (NYSE:IBM) in the past.
One of the other real kernels of the BWYK philosophy is that you shouldn't overlook obvious opportunities that you see in your day-to-day life. For instance, I think that anyone who saw the success of the new Cheesecake Factory (NASDAQ:CAKE) restaurants or Motley Fool Inside Value pick Home Depot (NYSE:HD) stores in the early days knew these folks were on to something special.
The real BWYK
Clearly, there's more than a little truth in BWYK. After all, if you're just buying and selling stocks with no particular knowledge of the companies, you're trading -- not investing. So let me offer up my personal reworking and interpretation of how I think BWYK should work.
First, make a concerted effort to identify companies led by straightforward, honest, and competent managers. We all know that there is no business so idiot-proof that any random person off the street could run it successfully, and we've all personally experienced what competent (or incompetent) managers can do to companies. Given that businesses, companies, and industries change over time, I think that knowing the quality of the management team is a very important factor in knowing a company.
Second, research the company, its competitors, and its industry enough that you can identify which competitive advantages and edges really matter. Stock Advisor pick Dell (NASDAQ:DELL) succeeds not because it offers the most sophisticated machines -- it succeeds because it offers customizable systems at great prices and with good quality. Likewise, Nordstrom succeeds not because of a lowest-price policy, but rather because of its commitment to above-average service and quality.
Once you know an industry well enough to understand why the winners are winners, you can invest much more successfully. You need to be able to understand those edges, who has them, and how the industry is evolving. If you're not sure how to begin, I'd suggest going to your local library and checking out a copy of Michael Porter's Competitive Strategy, one of the best works on the topic.
Finally, make sure you conduct your own personal, thorough research. Don't invest just because your broker suggests something or some analyst, writer, or manager likes a company. You need to know the company and why you're investing in it.
Think of investing not as buying shares in companies with the vague intention of getting rich, but rather as becoming a co-owner in a business enterprise. If your neighbor came to you and said that he had developed a fuel cell or some nanotechnology in his garage and had a deal with a company in China, how much money would you be willing to give him?
Exactly.
I honestly believe that's the lost message in BWYK -- not that you should restrict your stock research to companies or industries that you already know, but that you shouldn't invest your hard-earned cash into a business until you know it well. That's why we at The Motley Fool always push our readers to do their own research and make their own choices. With so many free tools at your disposal, take advantage of this age of information to broaden your knowledge base and use that knowledge to find the much-better-than-average companies out there.
To get to know more Foolishness, acquaint your mouse with these:
Home Depot is an Inside Value pick. Best Buy and Dell are Motley Fool Stock Advisor picks.
Knowing as much as you can is very important when assessing the value of a company. And that's what Philip Durell does with every Inside Value recommendation. To learn more, you can try Inside Value risk-free for 30 days.
Fool contributor Stephen Simpson has no financial interest in any stocks mentioned (that means he's neither long nor short the shares).
