There's an old financial adage that you should invest in what you know. It seems like decent enough advice, but there are a couple of reasons it can backfire.
Plenty of investors have said this, but the quote is usually attributed to Fidelity's Peter Lynch. And while you should have a basic understanding of how investing works, a lot of people take this advice to mean "only invest in industries you're familiar with". But one financial advisor tells Bankrate how this can backfire:
"We have seen clients in certain industries like health care have a portfolio full of health care stocks," Antenucci says. "They become enchanted with these companies because they're familiar with them. These clients end up with a portfolio with greater risk level than having a diversified portfolio of stocks and bonds from a variety of different sectors and countries."
The lack of diversification can make it tougher to ride out an industry downturn.
"If your job is in health care and the health care industry is under pressure in general, then there's additional risk that your investment portfolio can also be going down at a time where you may lose your job," Antenucci says.
If "what you know" means having a diversified portfolio of index funds meant to mirror the broad market, that's one thing. But just because you work in an industry and you're familiar with it doesn't mean you can predict specific market fluctuations.
Financial advisor and New York Times writer Carl Richards further explains that the common understanding of this rule betrays its original context. It's supposed to be about learning, not picking stocks based on limited knowledge. Richards explains:
People are using it to justify dangerous investing decisions...
And Mr. Lynch isn't alone in being taken out of context. Warren Buffett has offered similar advice about how you should never invest in businesses that you don't understand.
But here's the thing we need to remember: Whatever the advice, it's just the starting point for investors like Mr. Lynch and Mr. Buffett, not the end point. Yes, they may have started with things they knew. But they also did a bunch of research, and it's this second part that's missing from many investors' decision-making process... I've heard more than one person justify a decision to buy Apple stock because they really love their iPhone. That's about as wise as buying Crumbs' stock because you love their cupcakes.
In short, the advice was never about hand picking stocks based on an industry you have a vague familiarity with. Anyway, a better bet is to invest for the long-term with a buy and hold portfolio. It's not as exciting, but it works.
5 Money Myths That Are Financial Nonsense [Bankrate]