"Don't invest in what you don't understand" is a good investment rule that comes from famous investors like Warren Buffett and Charlie Munger. Building on the idea of the "circle of competence" we talked about earlier, this principle stresses how important it is to make investment choices within the scope of your skills and knowledge.
Managing your risk is an important part of business. What you do should fit your risk tolerance and time frame. That's why you need to know what you're putting your money into. We show you what to watch out for by giving you some examples.
Putting eggs in different baskets
If you're planning to invest in a few stocks, it's important to have a good understanding of the investment you're making. For instance, changes in the price of oil might have an impact on your investments in companies that deal with transportation, haulage, and manufacturing. When the price of oil goes up, it generally hurts these businesses as their costs increase, which can lead to a decrease in their profitability and, subsequently, their stock prices.
One way to avoid the pitfalls of investing in a few stocks is to diversify your portfolio. Diversification means spreading your investments across a range of different assets and markets, which can help reduce your portfolio's overall risk. By doing so, you can avoid underperforming the index, which is a benchmark used to measure the performance of a particular market or sector.
However, diversification also comes at a cost. It means you won't be able to beat the index, which is one of the most exciting aspects of investing. Beating the index is difficult, but it's also what many investors strive for, as it can lead to greater returns. Nonetheless, diversification can be a smart investment strategy for those who want to reduce their risk and have a more stable portfolio.
However, if your goal is to beat the index and increase your overall returns, our research reports might help you get a slight edge!
Missing out
Warren Buffett, CEO of Berkshire Hathaway ($BRK.A, $BRK.B) and a famous billionaire on Wall Street, has said that he lost a big chance to make a lot of money by not investing in Amazon.com, Inc. ($AMZN) and Google, a subsidiary of Alphabet Inc. ($GOOG, $GOOGL). During the last 20 years, there has been a huge rise in technology that has made many people rich. However, Buffett has not made many investments in technology.
To be fair to Buffett, he has a good reason for not buying many technology stocks. When Google asked Buffett to invest in the company before its 2004 IPO, he turned them down because he didn't see how Google could give itself a profitable and long-lasting edge over its competitors.
"I had plenty of ways to ask questions or anything of the sort and educate myself, but I blew it," Buffett said about Google. But the chances he missed with Google and Amazon are just one example of Buffett in a much bigger picture.
He once said, "Never put money into a business you don't understand." Well, this also means you are missing out on potential multibaggers… That’s just how the game works.
Goods and service providers
Remember that you are the one who wants a better financial result, but this doesn’t mean just buying a few hot stocks or the ‘next best thing’. It might make sense for people not to put money into things they don't understand. However, it happens a lot, which is a shame.
The housing bubble of recent times serves as an example of such behavior. Many people purchased mortgage-backed securities without knowing that they included numerous bad loans or even comprehending the business or their actions' implications.
Companies operating in the science and technology sector usually offer services and products that are challenging to grasp for those who lack expertise in these areas. Similarly, investing in a cloud services company's new product line can be challenging for investors who are not knowledgeable about electrical engineering, software development, or a related field.
Buffett once said that he has three places where he keeps business ideas: in, out, and too hard. If a company's product or business is too hard to understand, it's better to just mark it as "too hard" and move on to something else.
The cloud could be a huge growth area in the coming years, but most investors might find niche cloud services stocks "too hard" if they don't know much about the field. Chris Zaccarelli, chief investment officer at Cornerstone Wealth, says that buyers should always keep in mind that a share of stock is like owning a small part of a business.
"Just as you would never purchase a private business from someone else without at least looking at its sales, profits, debt, and trends of all three of those things at a bare minimum, you need to do the same thing before purchasing stock in a company. "If you are doing anything else, you are just hoping what you bought will go higher, and hope is never a good strategy."
Investors may know everything there is to know about a business's goods but not about the company or its stock. This kind of stupidity is bad. We are naturally drawn to businesses that make things we like or offer services we believe are worthwhile. But interesting products or companies are not the same thing as good stocks. If the business model of a company isn't a good one, it may never be financially successful.
When it comes to investing, it's important to follow the age-old advice of "Don't invest in what you don't understand." This means sticking to what you know and making investment decisions based on your knowledge and skills. It's also important to manage risk by understanding the dynamics of your investments. Diversifying your portfolio can help reduce risk, but it may also result in lower returns. While diversification provides stability, those seeking higher returns often aim to beat the market index. In conclusion, seasoned investors like Warren Buffet remind us that risk comes from not knowing what you're doing.
Let’s finish with a quote that fits this theme.
"Diversification is a protection against ignorance." - Warren Buffett