As an investor, you have likely heard one piece of advice that many investment professionals consider to be the golden rule of investing. The saying goes: if you can’t clearly and briefly explain what a company does, you should not invest in it. For this article, we asked, how important is this advice and what fundamental aspects of a company’s business do you need to understand before considering your investment in that company?
With regard to the first part of this question, we know that this advice can be extremely important for all investors. In the following example, we will show why this is the case.
Take any pharmaceutical company, for example. As a new investor, you might have heard that this company’s stock – we’ll call it Stock X – is going to be an extremely promising investment in 2018. The financial writers you follow online have said that it’s a “sure bet” and that you would be wise to get in while you can. But, can you take this as your sign to buy the stock immediately?
This is one of the most common problems that young investors face and many of you, no doubt, have found yourself in a similar situation, regardless of what stock happened to be your “Stock X”. It seems only natural for us to want to trust the advice of investing professionals – especially when we feel like they are giving us the next “secret” to their investing success. But, without truly understanding this investment ourselves, we have only been shown a piece of the full picture.
Before we take this advice as our own and use it in our own portfolios, there are some very important questions we should be asking ourselves.
First, do we have any prior experience with this company or its products? First-hand knowledge of a company is one of the best motivating factors for making an investment, because experience with a company’s products can give you a positive or negative indication of the company’s future success. You can also use your past experiences with the company’s website, customer service, and marketing campaigns to guide your investment-making decisions.
Next, do you understand the company’s business model? The answer to this question will make up the other major half of your true understanding of the company. For example, companies such as Google and Facebook have business models that are relatively easy to understand, but the business model for our Company X may be far less simple. This could be an indication that there are other, better investments out there for you to make. The ultimate point is that, especially as a new investor, you need to know how the company has prepared itself to make profits in the future, so that you can believe that its investors might be able to do the same.
Lastly, if you can easily articulate your interest in our hypothetical Stock X, you might say something like “the company makes a variety of products, but is most known for its every-day hygiene products, like toothbrushes. Thus, the majority of this company’s profits come from sales of these products and re-sales when customers need new products.”
Of course, this is just one basic example, but statements like these show that an investor is familiar with the company and that he or she understands the fundamental aspects of the company’s business. This could be an indication that the investor has done good research prior to making his or her investment and feels comfortable jumping in. So, next time you are considering an investment, try to give a two-sentence description of the company in question to test your knowledge!