Warren Buffett (Trades, Portfolio) has famously said to 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 said, “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 conventional 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’s said you must have a “specialized knowledge” of a company and its industry to “know” a stock. He said, “Someone with deep restaurant industry experience would have predicted the success ofPanera Bread Co. (NASDAQ:PNRA) and Chipotle Mexican Grill Inc. (NYSE:CMG) If you are in the steel industry and it ever turns around, you will see it before I do.”

There is no denying that Warren Buffett (Trades, Portfolio) 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 is 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 are familiar with limits your options and causes overconfidence in your decisions.

Here is 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.

According to a write-up in AAII Journal, Peter Lynch believes investors should thoroughly familiarize themselves with a company in order to “form reasonable expectations concerning the future.” AAII goes on to say, “[Lynch] suggests that you examine the company’s plans — how does it intend to increase its earnings, and how are those intentions actually being fulfilled?”

The obvious question is: how familiar should an investor be with a company before purchasing its stock?

Warren Buffett (Trades, Portfolio) provided his opinion during a 1998 lecture at the University of Florida:

“Now I did a lot of work in the earlier years just getting familiar with businesses and the way I would do that is use what Phil Fisher would call, the 'Scuttlebutt Approach.' I would go out and talk to customers, suppliers, and maybe ex-employees in some cases. Everybody. Every time I was interested in an industry, say it was coal, I would go around and see every coal company. I would ask every CEO, ‘If you could only buy stock in one coal company that was not your own, which one would it be and why?’ You piece those things together, you learn about the business after a while.”

Buffett literally talked to everybody before buying a stock: customers, suppliers, employees, competitors and CEOs. If that is not impractical for a small investor, then what is?

It is dangerous to only invest in companies you like, understand or are familiar with. Doing so will inevitably cause investors to be too optimistic about a company’s prospects. Thus, leading to buying at the wrong time and overpaying for a stock.

Workplace bias

If you follow Peter Lynch’s advice to invest in the industry you work in, you will most likely end up just investing in the company you work for. Statistically, people are more likely to be optimistic about their employer’s prospects than the prospects of their employer’s competition.

According to a New York Times article, employees consistently overweigh their 401K investments in their own company’s stock. The article points out the folly in this:

“Given the employment risk you already face by getting your income from a single source, do you really want to bet even part of your retirement money on that company? How much do you really know about its prospects, its competitors and forces way beyond your control? And how much are you willfully blind to?”

In other words, you already rely on your employer for a paycheck, why have your investments rely on them too? Who is to say your company is not the next Enron?

Favoritism

Similarly, it is a mistake to invest in a stock just because you like the company’s products. This is an all too common practice by individual investors. In fact, so many people buy stocks based on their favorite products that Peter Lynch recently had to clarify his advice.

In a late 2015 Wall Street Journal article, Lynch stated, “I’ve never said, ‘If you go to a mall, see a Starbucks and say it’s good coffee, you should call Fidelity brokerage and buy the stock.’” Instead, he implies that liking a company’s product is considered “specialized knowledge.”

The article explains his thinking this way: “Use your specialized knowledge to home in on stocks you can analyze, study them and then decide if they’re worth owning.”

Using your favorite products as a starting point for stock selection is never a good idea, no matter how much further analysis is performed. It is too easy to get distracted and let the excitement of a trendy product interfere with objective fundamental analysis.

Limited options

When you only invest in companies you are familiar with — whether it is the place you work or a product you love — your options are extremely limited. Warren Buffett (Trades, Portfolio) admits this: “And if that circle only has 30 companies in it out of thousands on the big board, as long as you know which 30 they are, you will be OK.”

Is it really OK to limit yourself to 30 investment opportunities? The odds of finding one — let alone multiple — undervalued stock(s) in your specific circle of competence is minuscule.

It is hard enough to find high-quality value stocks in the market. It is nearly impossible to find good investments when you only invest in what you know.

Portfolio formation

If individual investors should not listen to Warren Buffett (Trades, Portfolio) or Peter Lynch’s advice, whose advice should they take?

For any true value investor, the answer is obvious: Benjamin Graham.

In 1976 — after more than 60 years on Wall Street — Benjamin Graham gave a Q&A interview with Financial Analysts Journal. When asked which investment approach he recommended for individual investors, his answer was profoundly simple:

“Essentially, a highly simplified one that applies a single criteria or perhaps two criteria to the price to assure that full value is present and that relies for its results on the performance of the portfolio as a whole–i.e., on the group results–rather than on the expectations for individual issues.”

The father of value investing believed that individual investors should use a simple stock selection strategy to build their portfolios. He favored buying a group of undervalued stocks based on only one or two criteria.

Rather than trying to be the next Warren Buffett (Trades, Portfolio) or Peter Lynch, do what is practical and intuitive by following Graham’s advice.

This article appeared first on The Stock Market Blueprint Blog.

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