Wednesday, May 29, 2013

A Losing Strategy: Investing In What You Know

If you are over the age of 50, you probably remember Peter Lynch. He was the famous manager of Fidelity’s Magellan Fund from 1977 to 1990. Over those 13 years, Mr. Lynch achieved a compounded average investment return over 29%, while the S&P 500 Index only rose 15.8%.

Adages of Peter Lynch: “Never invest in any idea you can’t illustrate with a crayon.”  and “ Invest in what you know.”  People use these statements to justify terrible investing decisions. Warren Buffett has also offered similar advice about how you should never invest in businesses that you don’t understand.

But here’s the thing you need to remember: It is just the starting point for investors like Mr. Lynch and Mr. Buffett, not the end point. Yes, they may have started with things they knew. But they also did a ton of research, and it’s this second part that’s missing from many investors’ decision-making process.

A study was done to see if individual investors could outperform a benchmark essentially by buying what they know.

Summary of the findings:
  • Individuals failed to diversify
  • Folks that invested in “what they know” did 5% worse than the index
  • The stocks they sold outperformed the stocks they bought by about 4%
Peter Lynch advocated buying what you know. And research into human behavior demonstrates that people prefer to bet in a context where they consider themselves knowledgeable or competent.

The authors of “Why Smart People Make Big Money Mistakes," noted: "For every example of a person who made money on an investment because she used a company's product or understood its strategy, we can give you five instances where such knowledge was insufficient to justify the investment."

Keep these findings in mind the next time you're tempted to invest in what you think you know.

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