By Peter Mastrantuono
The legendary investor, Peter Lynch, long ago recommended that Americans “Invest in what you know.” But, does it make sense?
The idea of investing in what you know has a strong appeal. It’s an approach understandable to every investor, and it has the scent of common sense. Imagine the routine experience of attending exercise classes and witnessing a growing number of classmates wearing Lululemon’s athleisure products. A buy of LULU at its initial product offering price of $18 per share in 2007 would have been a very savvy and profitable investment. (Today, LULU trades at over $200 per share—or over $400 pre-split.)
Of course, those same eyes might have seen something similar with another athletic wear company, Under Armour, which has had a less successful go of it.
The takeaway from this is that investing in what you know can be a fruitful approach to identifying good investment ideas, but it can never be the only criterion for selecting stocks in which to invest.
Indeed, Peter Lynch never meant for his principle to be a standalone one. Consider the many, very familiar companies that were well liked by consumers, until they weren’t: Kodak, Zynga, J. Crew, Groupon, Compaq Computers, Blockbuster Video, Pets.com, Toys R Us and Radio Shack.
These companies would have, at one time, surely qualified as attractive investments using the principle of “invest in what you know.” For different reasons—the inability to innovate or respond to a changing competitive landscape, or poor financial management—these companies would have been disastrous investments.
That’s why it’s crucial that investors go beyond name recognition and do much more research about the company and its marketplace. For instance, how much debt is the company carrying? Can they service it? Is there room to grow their sales? Have profits grown over time or appear to be leveling off? Do they have a record of innovation? Is their market being disrupted by new competition? Do they have cash reserves to see them through a recession? Are their customers loyal or fickle? Is there reputational risk? Is the management team stable? Are insiders buying or selling the stock? Etc.
Another factor of which investors should be aware is that investing in only companies to which they have direct, everyday exposure is unlikely to lead to a fully diversified portfolio. There are many good investment opportunities in companies whose produce products or services are not present in an individual’s life and therefore could be overlooked.
Owning stocks of companies whose products or services are regularly used can establish a more direct, even emotional, connection with owning that stock, and that can lead to violating a very important investing rule: “Never fall in love with a stock.”
So, yes, start looking into investing in companies you know but use a financial advisor to help you do the research that can help identify the winners and avoid the losers.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.