Investing: “Buy what you know” is a bad strategy

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CBS Money Watch

Original article by Larry Swedroe

March 23, 2012

We’ve all been there.  We have a gut feeling about our favourite company.  We think because we love their products or their press that we really know the company, almost as an insider. How could we go wrong? If we love the company, many others must as well. Seems like a sure thing. So, we go ahead an invest in their stock. Or, as Larry Swedroe discusses here, we work in an industry sector and we feel we know the market, the competition and all the upsides (and downsides).  Who could know better than us what the future would bring. So we make what we see as a sure investment in our sector.  We trust our gut and make decisions on that basis.

Investing in the same industry as your occupation hasn’t yielded better results for investors.

Peter Lynch was one of the most successful mutual fund managers we’ve seen. One of his strongest pieces of advice was to buy what you know. In fact, the title of one of his books was “One Up on Wall Street: How to Use What You Already Know to Make Money in the Market.” But is this actually good advice? The authors of the recent study, “Do Individual Investors Have Asymmetric Information Based on Work Experience?,” put this theory to the test.

The goal of the study was to see if individual investors preferred “professionally close” stocks (meaning stocks of companies in fields related to their profession) and if they could outperform a benchmark essentially by buying what they know. The study also looked at the performance of investors buying stock of the companies they work for, as well as other companies near where they live. The following is a summary of their findings:

  • Individuals failed to diversify their human capital, overweighting stocks in their industry of employment.
  • Individuals didn’t earn abnormal returns when trading professionally close stocks. On a one-year level, a portfolio of stocks related to investors’ areas of expertise had a negative alpha of about 5 percent (meaning investors performed worse than the benchmark). Also, the stocks they sold outperformed the stocks they bought by about 4 percent annually.
  • Individuals traded excessively in professionally close stocks, showing that investors felt more confident trading stocks of companies they knew.
  • Advanced degrees didn’t provide any benefit. Those with a Ph.D. didn’t generate abnormal returns.
  • Local proximity provided no advantage.

The authors concluded: “Our findings are consistent with both familiarity and overconfidence being the behavioral driver behind our results.”

When we are dealing with money, we know that we are dealing with a complex mix of emotions.  Money is our life, it’s our past and it’s our future.  How can we expect ourselves not to be emotional when so much is riding on this one variable.  Money represents all our hopes and fears.  Money can provide us with the future we always dreamed of or it can lead us down a path of ruin.  We know that people are often overly confident about their investing acumen.  Many studies have shown that when investors are asked about their investing skill, they often over-estimate their success rate. Yet, when we look at actual returns, they never measure up to the belief that investors have about how well they perform.  This is why a financial professional is so important when making critical investment decisions.  A professional has the advantage of objectivity and brings a much need rational mind to the process.  They trust their rational skills and understand that to trust their emotions alone is truly a dangerous strategy.

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 rather than in a context where they feel ignorant or uninformed. Unfortunately, as Gary Belsky and Thomas Gilovich, 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.” The results shown above demonstrate that Belsky and Gilovich got it right.

The findings from this new study provide clear evidence of behavioral biases in the investment choices of individuals and add to a large body of evidence demonstrating the general tendency of investors to hold stocks of their employers and other companies they feel they know. Unfortunately, this goes against one of the principles of portfolio theory — diversification is the only free lunch in investing, so you might as well eat a lot of it. Keep these findings in mind the next time you’re tempted to invest in what you think you know.

Remember, you are often not aware of your emotional connection to your money and your investment decisions.  It makes great sense to consult with a professional, if only for a second opinion. That move could make a difference between financial success and financial failure.

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