Should You Really Invest In What You Know?

Warren Buffett has famously said, invest in what you know. This line of thinking is what many have attributed to his foresight to stay out of the internet bubble in the late 1990s.

Likewise, Peter Lynch is known for having an almost identical mindset. He says, "The best way to invest is to look at companies competing in the field where you work."

What does it mean to invest in what you know, and is this popular-wisdom good advice for individual investors?

Invest in What You Know

According to Buffett, an investor must understand a company's products and its business model before making an investment. He calls this level of understanding a "circle of competence."

Peter Lynch says you must have a "specialized knowledge" of a company and its industry to "know" a stock. He says, "Someone with deep restaurant-industry experience would have predicted the success of Panera Bread Co. (NASDAQ:PNRA) and Chipotle Mexican Grill Inc. (NYSE:CMG) If you're in the steel industry and it ever turns around, you'll see it before I do."

There's no denying that Warren Buffett and Peter Lynch are among the most successful investors of all-time. However, their advice to invest in what you know is not only impractical for individual investors, it's also dangerous. Small investors who follow this advice will inevitably lose patience and throw in the towel.

Investors do not need to like, understand, or even be familiar with a company and its products before buying its stock. In fact, they should try to avoid making investment decisions based on this type of qualitative information.

Why is it so dangerous to invest in what you know? In addition to being impractical, investing in companies you're familiar with limits your options and causes overconfidence in your decisions.

Here's an overview of why you should not invest in what you know.

Impractical

To know a company is to deeply understand the inner workings of the business; including but not limited to its managers, employees, customers, suppliers, competitors, etc.

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