Legendary investor Warren Buffett, among others, is notorious for telling investors to buy what they know. Basically, Buffett and his enthusiastic followers suggest investing in companies that you really understand or at least know enough about them to be able to explain how they make money - i.e. the company's business model. Though it's certainly not without merit, buying what you know is not necessarily an investment strategy that will yield the most investing success. There are some limitations to this strategy that suggest investors might really be better served by buying into what they can learn.

SEE: Investing 101Tutorial

It Takes Time To Fully Understand A Company
Many new investors will find it difficult to delve into the business models or 10-k statements of publicly traded companies for some obvious reasons, the most important being time and/or lack of knowledge. Not many of us can listen consistently to companies' earnings calls and even if we could, we might not really appreciate what is being discussed. Truly understanding a company's balance sheet and overall financial direction requires specialized knowledge that most investors do not immediately possess. There are, however, many online resources that can help shorten the learning curve on gaining knowledge about a company you own or have intentions of buying.

Such sites can bring you up to speed on companies and their future prospects. Of course, there is an extent to what the services provide without paying a fee, but the amount of free information that can be learned over time is certainly not negligible. The idea is to get a familiarity and not necessarily expert knowledge of your potential investment choices.

SEE: Morningstar Lights The Way

You Can Miss Out On Upcoming Companies
A pitfall in just investing in companies that you are comfortable with is the opportunity cost of not owning companies not as prominent. Most investors know that Exxon Mobil sells gasoline and that Johnson and Johnson make a variety of pharmaceutical and health and beauty products. A valid argument can be made that these companies bring predictability and help mitigate risk in one's portfolio, however, the fact remains that the biggest gains from stocks typically come from companies in the earlier phases of growth instead of the latter phases.

Typically, big well known companies cannot grow at the pace they did when they first became publicly traded. So then the idea is to learn about these companies before they experience their biggest growth and consequently their most explosive stock price appreciation. Cisco Systems and Microsoft are two of the most recognized technology companies on the planet. Microsoft went public in the '80s. Back then, not many people really understood "Windows" or "email," which have become essential and necessary in everyone's lives. In the early '90s, who knew what the internet was, much less that it would eventually be used without wires and in conjunction with routers? Cisco systems certainly did, and learning conceptually about this company and pulling the trigger would have earned huge returns on an investment. There are also online sites that help navigate thru some of the most recent companies and potential high growth stocks. No one should go out and invest solely into small, growing companies or recent IPOs, but learning about these companies could make you a more balanced investor.

SEE: Why Warren Buffett Envies You

Don't Only Focus On The Future
Another tenet of investing purists is the utmost importance placed on fundamental analysis. Metrics such as forward price-to-earnings ratios, book value, price-to-earnings growth rates and free cash flow are just a few of the many data points used to determine if a stock is worth owning. Most of this analysis is based on assumptions at least one year into the future. Using these metrics, fundamentalists and analysts try to peg a "target" price one year into the future.

Instead of trying to figure out what all this jargon really means, why not look at a picture of what a company has actually done instead of what it is projected to do? A stock's chart tells you what it is valued at the moment you pull it up. Many stock technicians, those who focus on a stock price intensely, would probably agree with the old adage that a picture is truly worth a thousand words. Investors should consider using technical analysis for companies they do not "know" or really have no time or desire to learn either. Doing some homework and learning basic stock charting trends along with terms such as moving averages, breakout and candlesticks can open new doors to stock analysis.

SEE: Technical Analysis Tutorial

The Bottom Line
Buying what you know is certainly relevant, practical investing advice. However, only buying what you know introduces risk to your portfolio: Many of the biggest returns will be made from companies you have never heard of and do NOT understand. Investors may be wise to invest in companies that they can learn about instead of sticking only with the tried and true of what they supposedly "know."

Exploring alternative approaches such as learning basic technical analysis and following recent IPOs will help broaden investors' horizons.

Related Articles
  1. Economics

    Understanding Cost-Volume Profit Analysis

    Business managers use cost-volume profit analysis to gauge the profitability of their company’s products or services.
  2. Fundamental Analysis

    5 Must-Have Metrics For Value Investors

    Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know.
  3. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  4. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  5. Stock Analysis

    The Top 5 Micro Cap Alternative Energy Stocks for 2016 (AMSC, SLTD)

    Follow a cautious approach when purchasing micro-cap stocks in the alternative energy sector. Learn about five alternative energy micro-caps worth considering.
  6. Stock Analysis

    Analyzing Porter's Five Forces on Under Armour (UA)

    Learn about Under Armour and how it differentiates itself in the competitive athletic apparel industry in light of the Porter's Five Forces Model.
  7. Stock Analysis

    The Biggest Risks of Investing in Qualcomm Stock (QCOM, BRCM)

    Understand the long-term fundamental risks related to investing in Qualcomm stock, and how financial ratios also play into the investment consideration.
  8. Stock Analysis

    The Biggest Risks of Investing in Johnson & Johnson Stock (JNJ)

    Learn the largest risks to investing in Johnson & Johnson through fundamental analysis and other potential risks. Also discover how JNJ compares to its peers.
  9. Chart Advisor

    3 Charts That Suggest Now Is The Time To Invest In Real Estate (VNQ, SPG,PSA)

    Real estate assets have some of the strongest uptrends around. We'll take a look at three candidates poised for a move higher.
  10. Investing Basics

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
RELATED FAQS
  1. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  2. What items are considered liquid assets?

    A liquid asset is cash on hand or an asset that can be readily converted to cash. An asset that can readily be converted ... Read Full Answer >>
  3. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  4. What is the formula for calculating the debt-to-equity ratio?

    Expressed as a percentage, the debt-to-equity ratio shows the proportion of equity and debt a firm is using to finance its ... Read Full Answer >>
  5. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
  6. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors insight into how efficiently a company (or more specifically, its ... Read Full Answer >>
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center