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Daily Traders Edge

Opinion: The idea of ‘investing in what you know’ is more dangerous than you think

July 18
10:05 2018

Recently one of us was talking to a financial adviser from a medium-sized town in the South.

A fried chicken restaurant in the town, a favorite among locals, had just announced plans to expand regionally with the ultimate goal of becoming the next Shake Shack or Chipotle. The adviser’s phone was ringing off the hook with requests from his clients to invest in the venture. When he attempted to explain to them the complexity of the restaurant industry and the incredible risk associated with such an investment, he was met with a common refrain: “How can this go wrong? The chicken is so crispy and delicious.”

His clients’ enthusiasm makes a certain intuitive sense. One of the most common pieces of financial advice we hear is to “invest in what you know.” The advice is rooted in the philosophy of famed investors like Berkshire Hathaway’sBRK.B, +3.77%  Warren Buffett, who has attributed his success to staying within his “circle of competence.” As the chicken example suggests, lay investors often misinterpret and misapply the philosophy, confusing a vague feeling of understanding with the fundamental research that Buffett and others are advocating.

Peter Lynch, another investor closely associated with the philosophy, recently lamented, “I’ve never said, if you go to a mall, see a Starbucks SBUX, +0.25%   and say it’s good coffee, you should call Fidelity brokerage and buy the stock. … People buy a stock and they know nothing about it.”

Conflating issues

New research of ours, forthcoming in the Journal of Marketing Research, sheds light on why people are so apt to misunderstand the “invest in what you know” philosophy: People tend to conflate their sense of understanding of what a company does with the risk of investing in the company. When we think we understand what a company does, like making great chicken, we judge it to be a safer investment. Unfortunately, people’s sense of understanding of what a company does is completely worthless as a guide to actual risk, meaning that relying on it is an unwise investment strategy.

In a first series of studies, participants read company descriptions of all companies in the S&P 500 Index SPX, +0.01% These descriptions include information about what the companies do, what its major lines of business are, where it is headquartered, who the CEO is and so on. We asked people to rate how well they understood what the company does and also asked them to rate how risky it would be to invest. Companies rated as easier to understand were rated as substantially safer. But when we collected data on the actual risk of the companies such as measures of volatility and rate of return, the easier-to-understand companies were no safer.

We also measured people’s risk perceptions in a more precise way, by asking them to make numerous guesses about how the stock would perform over the next year. People predicted that easier-to-understand companies would perform better and their guesses also fell within a narrower range, suggesting they thought performance was more predictable. Again, neither of those beliefs was borne out when we looked at the actual risk data.

Continue Reading at Market Watch

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