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Picking Stocks: Avoid What You Know


Picking Stocks: Avoid What You Know

Contributed by: martingale

Investing Many people think that you should only invest in the things you know well. Famously, Peter Lynch wrote in books like One Up On Wall Street that you should be able to pick great stocks by reflecting on things you see in your job and in your daily life. Accordingly, computer programmers tend to invest in software firms, doctors in drug companies, and bankers in financial services, each believing that their expertise in their industry will help them earn an improved return.

It sounds like common sense, but it's dead wrong. Investing in what you know is the last thing you want to do. To understand why, we will have to think a little on the nature of risk.

Let's recap what we mean by investment risk: When you invest in the stock market, the stock you bought might go down or the market might crash. We call the money you would lose if a company went bankrupt your exposure to that company. Some kinds of risks can be eliminated through diversification: If you buy just one company's stock and it tanks, you've lost everything, but if you bought ten stocks you could tolerate a bankruptcy or two, if the other eight did fairly well. In general, you want to have a little bit of exposure to a lot of things, rather than a lot of exposure to just one thing.

Your job itself is also a kind of investment. To get where you are today you invested years of your time (and lots of money!) going to school to acquire the appropriate credentials. You then invested several more years working hard and making all the right connections. We can think of your current salary as the "dividend payout" on the investment you've made in your career. All things considered, that's an enormous investment!

In terms of risk, you now have a very substantial exposure to your industry, and especially to the company you work for. If your industry falls on hard times, or your company folds, you stand to lose a lot--your job, and the salary that goes with it. You're also exposed to the Canadian economy in general if a recession could throw you out of work. The nightmare scenario is having all your savings invested in your own industry, and then losing both your savings and your job in an industry wide meltdown. You'd be unemployed, with no savings to live on. You want to avoid this scenario at all costs.

Even if there's no great catastrophe, the odds are you will experience minor setbacks in your career at times when your industry is in a slump. You might have to sell a few of your investments along the way to get by. If those investments are in the slumping industry, you'll be forced to sell them when they're low--a time when you'd rather be buying. You'd prefer to sell something that was up, or at least holding steady.

As a sensible investor you should try and reduce this risk--get some investments in other companies, in other industries, and other countries. It'd be particularly good if your investments were independent of your job (statistically speaking). That way, if your industry crashes, you could live on your savings while you learn a new trade. You want to make investments that have as little as possible in common with your job. Better yet, they ought to have nothing to do with Canada, so that your savings will survive the next Canadian recession.

Most people should avoid investing in their own industry like the plague. If you are a computer programmer the last thing you should do is invest in software. If you are a doctor the last thing you should do is invest in drug companies. Your personal knowledge of the industry already pays you a handsome dividend in the form of your salary--there's no point in compounding the risk you face by throwing your savings in too.

Furthermore, the odds are that you're already over-exposed to anything you know a lot about, even outside your industry. For example, you may know quite a bit about some companies that operate in your city, that have nothing to do with your industry. But if you own your own home, you're already over-exposed: a melt-down in the local economy will send both your property value and the local firm's stock price into the toilet. A general recession in Canada would threaten your job, your property value, and any Canadian company you might have invested in.

What should you do, then? You certainly don't have the time to become an expert in a lot of other industries in other places you've never been to. Your best option is to invest broadly in a wide array of different companies and industries, minimizing the consequences of picking one or two that aren't any good. An efficient way to do this would be to buy into an exchange traded indexed fund--one that buys a little bit of everything on the market. In particular, you should focus on foreign stock markets, those that have the least to do with your future employment prospects.

Draw up a "portfolio allocation" showing your exposure to different countries, industries, and regional economies. Work out how much exposure you have to your industry, to your province, to Canada, to the United States, when everything is included. Try and work out an overall sensible allocation of your investments that diversifies away these risks as much as possible.

It may still be that there are things you know a lot about that you have no exposure to--perhaps from a previous career in another city. By all means take advantage of that knowlege, but be careful! Don't invest again in your own industry--you already have a solid bet on that in your job.

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Don't Invest in What You Know (Updated)
Authored by: FrankW on Tuesday, December 21 2004 @ 04:04 AM EST

I buy your essential argument of not putting all your eggs in one basket (ie. the
industry or you are in or worse yet, the company at which you work). In fact, it
seems the contrary position might at times be advisable. That is if you can see that
some firms in your industry seem essentially doomed (ie. the emperor has no clothes)
then it might make sense shorting those stocks. This would be hedging your risk
in your industry. If the industry tanks you can make some money on the short position
while losing at your job (ie. limited raises or even losing your job).

That said, I have often wondered if it isn't easy to be fooled into wrong headed
investment decisions in an industry you are "too close to". For instance, I fairly
often think some companies I have technical knowledge about are likely doomed,
when in fact in many cases the technical weaknesses do not have as large an impact
as I instinctively feel they will have.
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