This week as I was looking at companies whose products I generally “like” I started thinking about legendary Magellan Fund manager Peter Lynch, who, decades ago, coined the phrase “buy what you know.” In other words, buy stocks of the companies you like, or in industries you’re familiar with.
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The idea is that if you understand what you’re investing in, you’re likely to make more informed, ultimately better choices. That advice has long been popular with investors. But in this age of 24/7 business news coverage, computer programs that can buy and sell stocks in microseconds, and social media that often makes the markets seem much more volatile than they really are, I wondered: Does “buy what you know” still hold water in 2023?
So, Does “Buy What You Know” Still Work?
Kind of. Buying what you know allows investors “to feel attached or close to their investments,” explains Neal Abrams, a personal money manager who counseled clients for 30+ years. When you buy what you know, you often develop feelings about your portfolio that you’d never have if you simply owned stocks picked by a professional money manager. This can be a good thing if it inspires you to actively engage with your portfolio more often, but a bad thing if it reduces your diversification in other industries (more on that in a sec.)
Follow the breadcrumbs and when we purchase products made by (or sold by) the companies for which we’re shareholders, we may then feel as if we’re contributing to the company’s success — and thus our own, as investors. “When you vote with your pocketbook, you are really giving your approval for the products made by the companies you love,” Abrams says.
Owning what feels familiar all boils down to having a level of comfort with your portfolio, explains Deborah Rounick, a financial advisor with Ameriprise in Philadelphia. But the advantages go far deeper than just the warm fuzzies. “You have a pretty good idea of the quality of the products made by the companies in your portfolio” when you’re an actual customer, Abrams points out. That means you likely know whether or not they’re raising their prices, if they’re playing with packaging that offers less for your money, and potentially whether or not they may be expanding their product offerings.
All of which is great. But…
‘Buy What You Know’ Can Blind Us To What’s Best for Our Long-Term Futures
A study by the Federal Reserve found that the median number of stocks held by individual investors was just three. And a more recent study on stock diversification by the National Bureau of Economic Research (NBER) showed that many people don’t appreciate the benefits of diversification in their investment decisions. In the latter study, participants often overweight individual stocks they perceived as high-quality, even when they had information indicating that a more diversified portfolio would perform better. Both of these findings are, well, problematic.
While it’s okay to buy what you like, you also need to understand the importance of diversification so you can create a broad (read: balanced and more able to weather the storms) portfolio.
“Investing is for those who are looking to grow their money over time, and the best way to do that is to have a well-diversified portfolio,” Rounick says. She cautions that when you only buy what you like/know, it can lead to a concentration among consumer companies in the same industry. “For the younger investors, what we don’t want to see is a portfolio of just tech stocks simply because that’s what they know the best,” she says. ‘Every sector goes through good and bad years as the economy changes and businesses mature. This is why it’s important to diversify across sectors to limit the portfolio risk, and more importantly, the impact on a client’s goals.”
If you’re only investing in what you know, you’re also likely only investing in companies where you buy the products — that means you may be missing out on exposure to bonds and other fixed income securities, Abrams cautions. That’s something you can address by understanding the importance of focusing on fixed income in your research, or by working with a financial advisor.
There are also some stocks that act as bond surrogates. Any stock that pays a dividend of 4% or better, offering relatively high current income, while also giving you the potential for capital appreciation [qualifies,] says Abrams. Because that’s the goal of bonds. “If you have exposure to these dividend-paying stocks, you may be setting yourself up to get the best of both worlds — income and growth potential — while maintaining needed diversification.”
Finally, on the diversification front, it’s also important to have exposure to different size companies, a combination of international and domestic investments, and positions on the value and growth side. Smart investors need to have a “mix of equities, fixed income, alternatives, etc., that can play a role based on your risk tolerance and time horizon. Since there are so many factors in investing, it helps to first prioritize your objectives and then allocate accordingly,” Rounick says.
How Do We ‘Buy What You Know’ Successfully?
It’s harder these days to buy what you know without also buying what you don’t know. There are fewer “pure plays” – companies that make one product or have one single strategy – than there used to be, so even buying what you know (or what you think you know) can help to diversify your portfolio.
Take Disney, for example. You may invest there because you like going to Disney theme parks. (I was just at Disneyland and take it from me, Millennium Falcon: Smugglers Run is a must — but try to sit in the front two seats.) Still, with every share, it’s important to understand that you’re also investing in streaming services, cruise lines, retail products and media networks (including ABC and ESPN).
“The key to investing in things that you know is to choose products in various markets so that you are properly diversified,” Abrams says, warning investors not to get stuck buying only, say, perfume or clothing when they can also invest in beloved companies that also sell food, cars, band-aids, computers, pet products or airline tickets, for example. “By diversifying across industries, you add a high degree of safety to your portfolio because you end up owning both growth and value companies,” Abrams adds. “You’ll benefit by naturally having investments in companies that may also offer dividends.”
As always, due diligence is essential. Doing your research is far more important than whether you personally prefer Target or TJ Maxx. As noted above, you may love your Peloton, but the company has had issues making money. Over the past year the stock price is down 42%. Likewise, you may know a lot of people taking Ozempic for weight loss, but that’s not the only reason to invest in a drug powerhouse like Eli Lilly, whose market cap is $410 billion. It has many other drugs in their pipeline and could be making — or losing — a fortune elsewhere. In other words, before you invest in anything — no matter how much you love it — ask yourself some important questions, including: How does it make money? Why do I like it? Why don’t I like it? And, would I buy it at this price? Then go even farther and also ask yourself: How does this position fit into my overall plan and bring me closer to my goals?
MORE ON HERMONEY:
- How to Handle Sudden Stock Market Moves
- Market Volatility: Is It Time To Get Used To It?
- The Two Economies and Stock Market Investing Today
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