Don’t just invest in what you know, invest in what you know you like

It has been called the Warren Buffett approach, invest in what you know. It’s a good approach, but not enough on its own.

Article updated: 18 June 2019 11:00am Author: Michael Baxter

I became a convert to Apple the day I realised how much I loved my iPhone. “I am surely not the only one who feels this way,” was my somewhat obvious insight, and I have waxed lyrical about the company ever since. I had a similar epiphany over Facebook when I grasped how cost effective it’s platform can be for advertisers.

But it’s not enough.

Warren Buffett is famously a fan of investing into companies he knows. So was my favourite deceased economist John Maynard Keynes.

In 1934, Keynes wrote a letter to F. C. Scott. Warren Buffett quoted this letter back in 1991.

Keynes wrote: “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes. It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence… One’s knowledge and experience are definitely limited and there are seldom more than two or three enterprises at any given time in which I personally feel myself entitled to put full confidence.”

Buffett has a similar philosophy, and indeed shunned investing in tech stocks because he didn’t understand the sector. That’s my biggest, nay, only criticism of Buffett, the way he avoided tech. But then again, invest in what you know. He didn’t know tech, so he didn’t invest. My criticism is unfair. Buffett is who he is, you can’t criticise someone for not being ‘into’ a particular sector.

That, however, is where one of the weaknesses lie with this approach. If the sectors you know well are in decay, then who do you invest in? If the sectors you know well happen to be in vogue, then you will enjoy good times. But then it is about luck, it is about the coincidence that your interests align with a booming or decaying sector.

Buffett also believed in value investing.

While Keynes believed in investing in a small number of companies, he believed in ensuring his portfolio was made up of non-correlated stocks.

If your speciality is tech — then the performance of your portfolio is subject to the tech cycles and can be vulnerable to a tech crash, as happened in 2000.

There is another risk in investing in what you know. Sometimes your knowledge can blind you to long-term risks. I know a lot of people who knew a great deal about cars and indeed the car industry, both as a hobby or from their jobs. Most dismissed the threat from electric cars and thought Elon Musk was a chancer peddling snake oil.

There is another problem with investing in what you know. You may only know stocks that are quite similar. So you end up with no diversification, and absolutely no non-correlated stocks whatsoever.

Investing in what you know is a good approach providing you apply other principles too. You need to take an objective look at yourself. If your knowledge horizon is too narrow, then to obtain sufficient diversification you will need to apply other methods too.

And don’t just invest in a stock because you know you like it. You need to understand its balance sheet too and understand if it’s good value. The company in question might be the best company in the world, but if the markets have already factored in the potential upside, then it still won’t necessarily be a good investment.

And you need to know stuff about a company that is not widely understood. I fell in love with Apple as an investment at a time when many were arguing that it had peaked. I could see how the market for the iPhone could grow many times over.

Your knowledge can derive from your expertise acquired from your job, academic studies or your hobby. You can admire a company because you once worked for a competitor or because you buy its products.

I have long said you can predict the fortunes of Marks and Spencer by watching my wife shop. She has been disappointed by the clothes section for years — and sure enough, the share price has reflected this. For what it is worth, the last time we were there she said it had the best clothes selection she had seen in years — but then that might have been because we had no money at the time, and things always seem to look better when you can’t afford them.

By all means, invest in what you know, but only if you know you like the potential, know its valuation relative to potential, know its weaknesses and know you have sufficient diversification.

These views are those of the author alone and do not necessarily reflect the view of The Share Centre, its officers and employees

Michael Baxter portrait photo
Michael Baxter

Economics Commentator

Michael is an economics, investment and technology writer, known for his entertaining style. He has previously been a full-time investor, founder of a technology company which was floated on the NASDAQ, and a director of a PR company specialising in IT.

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