Investing in What You Know

It is not uncommon for people who are new to investing to feel overwhelmed at the thought of deciphering financial statements. Another common obstacle is deciding where you should invest your money. Is it OK to invest in a company just because other people are?

Frankly, that’s not the best reason. In fact, a major pitfall that new investors face is not understanding a company's core product. What makes this company or this product unique? Why do you believe in the stock? What does the competition look like? Yes, it is important to understand a company's financial outlook, but I would strongly encourage you to invest in what you know. Read on to learn more about this approach.

Investing in what you know is not a new concept — some of the most prominent investors have practiced this principle. For example, Warren Buffett coined the term “circle of competence.”  He suggests that we all have areas of expertise, and people should only invest in what they know and understand. For one, this idea frees you from feeling like you need to be familiar with everything or study up on products or fields that you have no interest in. Moreover, by sticking to what you know, you’ll be able to more accurately assess a company or product.

Similarly, Peter Lynch said, "Never invest in any idea you can’t illustrate with a crayon." There’s no shame in keeping it simple, and no matter what area you know, you can make it work. For instance, if you work in fashion, you’ll understand the competitive landscape in that field better than if you were to invest in an industry completely foreign to you.

To be fair, investing in what you know can't be your whole investment philosophy: You’ve probably heard that you need a balanced portfolio, or diversified assets. Meaning, investing in what you know is not ideal if only you only know one thing, as that can lead you to having all of your eggs in one basket. Additionally, it’s unwise to consider an investment in isolation. You need to have a holistic view of a company, its competitors, and the economic environment. And it goes without saying that knowing a company isn’t a good enough reason to invest if the stock's historical performance or future outlook are dim.

Still, using what you know is a great starting point for researching potential investments, and it’s perfect for the beginner investor. So, start with your circle of competence, and push the boundaries from there.

Emily Washkowitz is a member of the DailyWorth Connect program. Read more about the program here.

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