By Jeff Reeves
One of the most dangerous investing ideas out there has been propagated by Warren Buffett acolytes who peddle the "buy what you know" mantra.
This simple turn of phrase, while seemingly sage investing advice, is actually a portfolio killer -- especially now, when financial media seems to be intent on pushing the "stock-picker's market" canard.
The bottom line is that buying what you know simply is not enough to invest profitably in 2013 -- and frankly, may never have been enough.
Right now there's a lot of fluff out there about how we may be seeing the return of a so-called "stock-picker's market" as Wall Street gets more selective, correlation drops between sectors and asset classes, and economic data remains muddled.
But the desire to pick stocks will ultimately end in tears for many traders, as it always has.
Investors can never really know enough about individual stocks to be protected. Disruption happens in a hurry these days, and companies including Borders and Blockbuster went from decent buys to doomed companies. And bigger picture, you can't know what a company doesn't want you to know -- whether it's blatant accounting shenanigans at Worldcom, or a more recent example where Groupon cited "material weakness" in its internal controls -- and its stock sunk.
Every company is at risk. Thinking you truly "know" a company is the kind of hubris that costs investors real money after they get overweight in a doomed stock or throw good money after bad when shares decline.
And let's not forget that academic research shows that diversification both across sectors and across asset classes is not just a lower-risk investment strategy, but ultimately one that makes you more money -- as long as you stick with it.
This is true even in the short term. In 2012, 63% of large-cap fund managers underperformed their benchmark, 80% of mid-cap funds underperformed and 67% of small-cap funds underperformed according to S&P research.
You think these fund managers didn't know the companies that they were buying? Or do you simply think you somehow know better?
Don't buy the story
I'll admit, it's hard to acknowledge your limitations -- especially if, like me, you think yourself pretty darn smart.
But acknowledging your limitations as an investor is a painful but crucial lesson.
One big but very formative investing mistake I made was in 2009, involving a biotech company called Thoratec (THOR) that makes artificial heart pumps. I had a friend who was a cardiologist who was excited by the products and his first-hand experiences, and he asked me to look into the company. It turned out the company was profitable and growing those profits. Furthermore, the narrative was simply amazing ... heart disease is the No. 1 killer in America, there aren't enough transplants, Thoratec's pumps have kept patients alive for months as they waited for their donor organ.
This wasn't some crazy med-tech startup whose shares could go to zero. This was an all-American success story, a medical miracle that a real-life medical doctor had clinical experience with and EPS that were marching higher. I couldn't lose!
Well, I did. My buddy and I bought Thoratec shares at about $30 in 2009 and sold it at $28 about a year and a half later. To add insult to injury, we missed out on a roughly 30% run for the market in the same timeframe.
"Buy what you know" was not the best strategy here. We knew a lot, and in fact probably knew more than many investors. But ultimately it didn't matter.
Buffett's actual advice
Before you hurl Coke cans in defense of Buffett or malign me for my personal investment decisions, let's be clear: my biggest point is that you can never truly know a stock or the market, and that risk is inherent in the market no matter what you tell yourself about a company's balance sheet or business model.
In fact, Buffett fans have taken his quotes out of context because they refuse to admit this hard truth about market uncertainty.
To me, the Berkshire Hathaway (BRKA) chairman's advice (BRK/A) becomes more powerful by the simple use of a different phrase to sum up his strategy: "Don't buy what you don't know."
This subtle shift puts the emphasis on risk and uncertainty; it is a warning instead of a call to action.
Such a rephrasing is indeed a much more faithful representation of the Buffett strategy, even if it's a little less empowering.
Consider that at the 1997 Berkshire shareholder meeting, Buffett famously said, "If you understood a business perfectly and the future of the business, you would need very little in the way of a margin of safety."
Read one way, this is a clear endorsement of going all-in with a stock if you're confident in your research. But read another way it is a warning, a cautionary tale about the importance of investing with an eye towards safety.
After all, who can understand a business perfectly? Who can truly know the future of a business?
Admittedly, this fatalistic approach to investing is no fun. We all like to feel like we are smart, that we can beat the market if we try hard and do our research, that the inefficiencies are made by others and exploited by us.
Sadly, that's not the case.
To those who think that "buy what you know" is a call to action, especially in the current marketplace where correlation is slipping and stock-picking is returning to favor, I would urge caution.
Because sometimes, you simply don't know what you don't know.
-Jeff Reeves; 415-439-6400; AskNewswires@dowjones.com
Subscribe to WSJ: http://online.wsj.com?mod=djnwires
(END) Dow Jones Newswires
09-12-13 0605ETCopyright (c) 2013 Dow Jones & Company, Inc.
|Gladstone Investment Announces Sale of Portfolio Company Venyu Solutions Inc. for $25 million Realized Gain ()|
|Brookfield to Invest in Shanghai Property Portfolio (2013/10/31)|
|UPDATE: Buffett vs. Twitter: Two smart #investing styles (2013/10/8)|
|UPDATE: Invest with Warren Buffett's five-year plan (2013/8/31)|
|UPDATE: Invest with Warren Buffett's five-year plan ()|
|Invest with Warren Buffett's five-year plan (2013/8/30)|
|UPDATE: Invest with Warren Buffett's five-year plan (2013/9/2)|
|UPDATE: Invest with Warren Buffett's five-year plan ()|
|Aberdeen Asia-Pacific Income Investment Company Limited Announces Performance Data and Portfolio Composition ()|
|TD Asset Management Inc. launches four new funds and an innovative investing approach to retirement - TD Retirement Portfolios ()|
|Start Premium Trial||Register For Free|
|P||F||Fund Financial Data (13,000+ funds)|
|P||F||Stock Financial Data (7,000+ stocks)|
|P||F||Stock and Fund Screeners (basic)|
|P||F||Investing Articles and Market Commentary|
|P||F||Articles Archive (>30 days)|
|P||F||Discuss (dozens of stock, fund, bond, and general bulletin boards)|
|P||F||Portfolio Manager (basic)|
|P||F||Morningstar Investment Classroom|
|P||F||Access Your Portfolio Anytime, Anywhere via Your Mobile Device|
|P||Morningstar Fund Analyst Reports (full research on 1,700 funds, ETFs, and CEFs)|
|P||Morningstar Stock Analyst Reports (full research on more than 1,100 stocks)|
|P||Portfolio Manager (advanced with 10 X-Ray analyses, including recommendations)|
|P||Portfolio Monitor (monthly and on-demand personalized portfolio statements)|
|P||Morningstar Proprietary Stock Information (stock star ratings, buy/sell prices, economic moat ratings, and more)|
|P||Morningstar 5-Star Stock and Fund Favorites & Red Flags eNewsletters|
|P||Premium Stock and Fund Screeners (advanced with nearly infinite ways to find the best securities for you)|
|P||Discounts on Morningstar newsletters, books, seminars, and more|
Access these features and more when you sign up for Free Membership.
Join Morningstar today. It's Free.
Access these features and more when you sign up for Premium Membership.
Start your free 14-day trial today online
Your subscription may be tax deductible. Please contact your tax advisor.