How 'buying what you know' can go wrong for investors

The advice sounds simple, but people who interpret it too simply can make unwise decisions

How 'buying what you know' can go wrong for investors

The classic advice from investment gurus, particularly those from the value-investing school of thought, is that one should invest in what they know. But investors tend to misapply the advice, investing in companies whose business models they understand without doing deep due diligence.

“When we think we understand what a company does, like making great chicken, we judge it to be a safer investment,” wrote academics Andrew Long, Philip Fernbach, and Bart De Langhe in MarketWatch. “Unfortunately, people’s sense of understanding of what a company does is completely worthless as a guide to actual risk.”

Citing their latest research, which is set to be published in the Journal of Marketing Research, they described how they asked people to read descriptions of all companies in the S&P 500. When the researchers asked compared people’s ratings of how well they understood each company as well as how risky it would be to invest in, they found easier-to-understand companies tended to be 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,” they wrote.

When asked how well they thought individual stocks would do over the next year, people’s expectations for easier-to-understand companies were more favourable and fell within a narrower range, suggesting that they expected performance to be more predictable. “Again, neither of those beliefs was borne out when we looked at the actual risk data,” the researchers said.

They also found that changing a company’s description to something more or less easy to understand makes it riskier or safer, respectively, in people’s eyes. And when asked to play the role of financial advisor to two clients — one young and risk-seeking, the other close to retirement and risk-averse — the participants recommended more easy-to-understand companies to the risk-averse client and harder-to-understand companies to the other, even with additional information such as analyst ratings and charts showing past performance.

Taking the research further, they repeated the financial-advisor exercise with experienced investors from an online investing community — individuals who trade at least weekly with portfolios of over US$100,000 in assets. “Those experts [also allocated] more to easy-to-understand companies for the risk-averse investor,” the researchers said. “The only difference from the novices is that they allocated a lot more to the easy-to-understand companies overall.”

The implication of the research, they concluded, is that lay investors should be realistic. Instead of risking money in companies that they don’t have the expertise or information to evaluate, most are better off putting their money in highly diversified assets that offer a set return over time.