The Pros and Cons of “Investing in What You Know”

Compass

“Invest in what you know” is a classic finance adage. It was the mantra of famed investor Peter Lynch, and is an approach followed by Warren Buffett. Indeed the general idea of investing in what you know makes a lot of sense and can help you avoid pitfalls that often bedevil investors. But taken too far even this seemingly common-sense philosophy can be counterproductive.

Let’s start with the benefits of investing in what you know. In recent years the number of financial products that investors can buy has proliferated, and many of them are complex and opaque. They often use derivatives or leverage or innovative investing strategies to try to outperform the market or mitigate a particular risk. In most cases these products are designed for a specific purpose, such as allowing hedge funds or professional traders to execute highly complex investment strategies.

While these types of products can seem sophisticated and alluring, they can also be risky if you don’t understand how they work. If the strategy they use isn’t consistent with your risk tolerance and time horizon, or you don’t understand how they interact with the other holdings in your portfolio, the results can be painful. For long-term investors simply trying to give themselves the best chance of reaching their financial goals, avoiding these newfangled products and sticking to what you know is often a better bet.

Yet investing only in what you know can backfire. Diversification is one of the keys to successfully managing your wealth, and focusing your investments only in the areas you know best can leave your portfolio insufficiently diversified.

An analysis by investing website OpenFolio found that investors tended to have more exposure to stock market sectors that were big employers in their part of the country. Investors in the western part of the US tended to own more technology stocks, for example, while investors in the Midwest tended to own more industrial stocks. While some of this effect could be due to employees receiving stock in their own company as part of their compensation, it’s also likely the result of investors being more comfortable with companies in the market sectors that they know more about.

This kind of “investing in what you know” can leave you over-exposed to a downturn in one particular industry. So while the philosophy of Lynch and Buffett can help you avoid some common investing mistakes, it shouldn’t come at the expense of a portfolio that’s well-diversified among different asset classes, market sectors, and regions of the world.