When Investing, Stick to What You Know

by Lee Distad

Warren Buffett can always be counted on for great sound bytes that offer sensible advice for every investor.

While not as pithy as some of his other statements, his advice that you shouldn’t invest in any business that you don’t understand is so obvious that it’s easy to lose sight of its wisdom.

Buffett is not the only one who counsels the importance of understanding what you’re investing in; lots of sensible advisors will tell you the same thing.

Do You Know What You’re Investing in?

One friend of mine who now trades derivatives on a large bank’s prop trading desk used to work in wealth management, which is a fancy way of saying he was a retail broker and financial planner. He told me that he would often field questions from eager-beaver clients who wanted him to either put money into companies they’d heard about in the locker room of their golf club, or to play complicated options strategies that they’d read about on the Internet.

He could have just taken their money with a smile, collected his fees, and then shrugged his shoulders when their can’t-fail scheme failed. Instead, he’d dig in his heels and ask them to clearly articulate the details.

What does this wonder company make? Who do they sell it to? What does their P&L look like? Explain every step of this option swap, and how it will play out.

If all his client could do was blink and stammer, it was pretty clear that their idea wasn’t a very good one.

Assuming as we do here at Automatic Finances that your investment decisions are based on a long-term, value-seeking, buy and hold strategy, one of the underpinnings of your decision making should be that you know what the industries or specific companies that you invest in actually do.

If you’re going to invest in a specific company, you actually need to read their filings and reports and understand what their numbers indicate.

It also means that you have to understand their industry. What does the playing field looks like? Do you have a realistic picture of their prospects?

This also applies if you’re going to invest in industry or region-specific exchange-traded funds, as opposed to the broader indexes.

Do Your Due Diligence

Due diligence is important. Find out as much as you can. It’s important to take an active hand in your education as an investor.

If you don’t do that, you’re ceding responsibility for your decisions, and letting other people do your thinking for you.

You may not be able to put in so much research that business news channels start asking you to appear on their shows to discuss the issues, but you need to make a conscientious effort to research your investment choices. If you don’t, you’re not really investing, you’re speculating.

The bottom line is that if an investing strategy is too complicated to untangle, it’s probably not right for you. If you’ve been given a “hot tip” about a company with an air of mystery around them, and you don’t know where the money comes from or where it goes, then don’t fret that you may be “missing the boat.”

You’ve probably heard variations of another piece of sage advice, delivered on-the-record by Warren Buffett: “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy.”

Do your due diligence, educate yourself, but don’t forget to stick with what you know and understand.

Lee Distad consults with CE integration firms on design, installation and project management processes and Best Practices, and offers provides professional copy writing services for websites, brochures, and marketing initiatives. His freelance work covers topics from CE to global business to finance in both print and online.

About the author: Lee Distad consults with CE integration firms on design, installation and project management processes and Best Practices, and offers provides professional copy writing services for websites, brochures, and marketing initiatives. Visit him at www.leedistad.com.

{ 1 comment… read it below or add one }

Chris Holdheide August 12, 2009 at 7:16 pm

Awesome article, I am adding you to my RSS and will be giving you a stumble as well.

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