Don't Invest in What You Know
Why an investing cliche isn't good advice.
There’s a terrible cliche in investing that just won’t die. “Invest in what you know.”
This concept has been attributed to famous investors including Warren Buffett and Peter Lynch. What Buffett meant by this was you should only invest in companies you understand. Lynch had a slightly different take, which was that you should invest in companies within your own industry because you would understand the inner workings more intuitively.
But this advice is better suited for professional investors of their caliber, not your average retail investor. The average investor should take another lesson to heart: Just because you “know” something doesn’t make it a good investment.
So what investments does the average person know? Well, there are large legacy companies like Coca-Cola, Kellogg, ExxonMobil and Bank of America. Then there are tech giants like Apple, Microsoft and Amazon, or even newer ones like Tesla and Meta. Most people can readily name these companies. And of course, you can’t forget about cryptocurrencies which have experienced massive gains (although not as of late).
Usually, the companies that people know tend to be flashy and trendy, like EV stocks and tech companies, or some of the better-known household names that have been around for decades. But companies that make headlines don’t necessarily produce the highest returns over time. We saw this with the dotcom bubble, and we’ve seen this with the tech stock decline over the past year or more. Companies, cryptocurrencies or asset classes in general are more likely to be known once they’ve produced large returns, but by then it’s often too late to get in as most of the money has already been made. And if what you “know” is crypto, investing in what you know can mean losing all your money.
Many times, the companies that produce the largest, most reliable returns over time are companies you will never hear about in the news. Think about value stocks. These are companies in the industrial, oil, gas and financial sectors that don’t get the attention that Apple, Tesla and Amazon get. Value stocks tend to outperform growth stocks over the long run, the post-2008 tech boom notwithstanding. The highest-performing stock in the S&P 500 in 2021 was Devon Energy, not exactly a household name.
So justifying an investment because you happen to be familiar with it doesn’t necessarily make for a great strategy. The idea of “invest in what you know” also assumes that the average person is even capable of truly getting to know individual companies enough to make a wise investment decision. Reading 10-K statements or other financial reports full of jargon isn’t exactly fun for most people, and those who claim to research the stocks they buy probably aren’t reading these things or could even understand them.
The idea of “invest in what you know” is so dangerous because while the average investor can’t truly know an investment, it can fool them into thinking they can. People like to think that they can do the work of getting to know a company before buying their stock, but in a way, this is worse than just selecting random stocks because it creates a false sense of confidence. You should probably leave stock picking to the pros, who do a terrible job themselves.
Now, you definitely shouldn’t invest in what you don’t know. This particularly goes for individual companies or random cryptocurrencies you heard hyped up on social media. However, you don’t need to perfectly understand every stock you own through an index fund, for example, for it to be a wise investment. Index funds have been shown to work because the market is efficient. So you can comfortably invest in an index fund without paying much attention to its composition. They’re meant to replicate the exact weight of the market and deliver higher average returns than actively managed funds after fees.
“Invest in what you know” as Buffett and Lynch taught generally applies to industry insiders — not individual investors looking to score higher returns by picking stocks.
Instead of investing in what you know, simply invest in the market. By doing this you’ll be investing in thousands of stocks you’ve never heard of, but it’s a far better strategy that will improve your investment returns over time.