When someone like legendary investor, Warren Buffett, entreaties you to “buy what you know” you are likely to take that advice. After all, the Oracle of Omaha has done well. Very well. The idea behind buying what you know is that investors who invest in companies they understand, they are less likely to make a bad investment and lose money. That said, there are limitations to “buy what you know” and it’s worth considering them before making a simple phrase your one and only investing philosophy.
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The Learning Curve Is Time Consuming
Nobody goes into investing with fully formed firsthand knowledge of every business or company into which they might want to invest. This means to know what you are investing in you will need to learn about business models, study 10-K statements and conduct fundamental in-depth analysis and that takes time.
Even if you are willing to spend the time, chances are you won’t have time to listen to earnings calls, study those balance sheets and learn about multiple companies at a deep level. Online resources – including sites like WooTrader and FinanceBoards can consolidate the information you need and make it readily available.
You Might Miss Out On Rising Stars
Sometimes companies pop up on the radar that are not well-known. These companies – if you pick the right ones – are more likely to reward you with larger and faster gains than you will see from more traditional and established companies. This is because well-known companies simply don’t grow at the pace of so-called rising stars.
You shouldn’t, of course, invest only in small, growing companies or recent IPOs. Learning about these companies and including the most promising ones in your portfolio could provide an opportunity to realize high growth along with the steady performance of your shares of larger, more well-established companies.
Geography Can Be A Limiting Factor
Another problem with the whole “buy what you know” philosophy is that it sometimes leads to investors who buy only stock in companies physically near them. The immediate red flag issue this brings up is lack of diversification. Each geographic area of the country typically specializes in certain industries. If you only buy stock in companies in your hometown that operate in an industry you know, you are putting all your bets in one part of the economy.
A good example of this would be if someone who lived in Seattle created an investment portfolio consisting only of Microsoft Corp. (NASDAQ:MSFTB) and Nike Inc. (NYSE:NKEC) stock. Those are not bad companies and not terrible stock to own but putting all your faith in those two industries is probably not a good idea.
On The Other Hand
Getting back to Buffett, it’s also worth considering his very sage advice around the simple notion that if you have zero understanding of a business, don’t buy it. To balance Buffett’s investing advice with the important concept of having a diversified portfolio requires learning something about every industry or sector into which you want to invest. You may not need to be an expert in each industry, but you should be knowledgeable enough to understand how the industry works and whether the company in which you have interest can be profitable and worth your investment.
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Don’t Overplay Your Hand
Since you should be somewhat knowledgeable, though not necessarily an expert, it’s important not to assume you can buy shares of stocks in ever sector there is. Buy stocks in companies you know and understand and mutual funds or ETF index funds for more diversity. This way you can concentrate in areas you really understand but keep a financial interest in the entire market.
The more specific your knowledge, the more specific your investing can be. When the industry or group of industries are outside your areas of expertise, don’t focus but rather invest in funds where the risk is spread out and expert managers are calling the shots. Or invest in passive index funds that don’t require specific management to track a group of industries.