If you’re just starting out as an investor you’ve probably heard or been told that you should “invest in what you know” as a starting point and that, over time, this is a way to save and earn money for the future. The idea here is that, if you consume certain products and are loyal to certain brands, those companies may also be solid investments. However, should you always invest in what you know?
Here’s what the supporters say:
Before we dive into the pros and cons of investing in what you know, let’s first establish that we’re talking about investing, not trading. What’s the difference? It’s really pretty straight forward: If you’re a trader, you’re buying and selling stocks frequently with the intent to beat the market in the short term. If you’re an investor, you have more of a long-term view and are looking to gradually build wealth.
The idea behind investing in what you know is that if you use a product and believe in a brand, then owning stock of that brand is a good place to start building your portfolio, especially if you’re new to investing and don’t know where to start. If you are an avid user of Facebook, for example, and believe that they will continue to grow their business, you may consider buying Facebook stock. On the flip side, if you know nothing about a certain field or industry, you may be better off not investing in it. Acclaimed investor, Warren Buffet, notably sat out of the Dot-com bubble in the nineties because he felt he did not know enough about technology as a field.
Here’s what the critics have to say:
Critics of the “invest in what you know” strategy claim that there is a high opportunity cost to only investing in what you know because that often translates to investing in large, well-known companies that most-likely cannot continue to grow at the pace they did when they first when public.
Opponents of the strategy are often not against the basic principle of investing in what you know, rather they believe the strategy is often not applied in the correct way. Simply owning an iPhone and deciding that, therefore, Apple is a good company to invest in may not always be the best long term strategy. It’s important to understand a company’s balance sheet and their strategy for growth.
So what should you, the investor, do?
If you’re just starting out as an investor, learning how to interpret a 10-k and analyze a company can be intimidating. For this reason, many people never start investing, which can be detrimental to their ability to gain financial independence.
It’s important to note that, over the long term, the stock market as a whole has shown positive performance. Perhaps the best thing for new investors to do is to focus on building a diversified portfolio rather than investing in one or two stocks. This means that you should build a portfolio of stocks or ETFs that span different industries and sectors. Diversification will help to protect your portfolio from volatility in the market and help you to achieve financial freedom in the long run.