Why You Shouldn't Buy Investments You Know

By Stephan Abraham AAA

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.

You May Also Like

Related Articles
  1. SIC Vs. NAIC -An Introduction To Industry ...
    Fundamental Analysis

    SIC Vs. NAIC -An Introduction To Industry ...

  2. An Introduction To Price Action Trading ...
    Trading Strategies

    An Introduction To Price Action Trading ...

  3. Investing In New York City REITs
    Mutual Funds & ETFs

    Investing In New York City REITs

  4. Technical Analysis Strategies for Beginners
    Trading Strategies

    Technical Analysis Strategies for Beginners

  5. Trading Volatile Stocks with Technical ...
    Trading Strategies

    Trading Volatile Stocks with Technical ...

Trading Center