Should You Really “Invest in What You Know”?

Peter Lynch headed Fidelity’s Magellan Fund for 13 years, turning $18 million in assets to over $14 billion and ensuring his place in the pantheon of wealth managers who achieved consistently extraordinary returns. With a gift for writing, Lynch penned several bestselling books, including including One Up on Wall Street, Beating the Street, and Learn to Earn. Two quotes that stand out in Lynch’s books are, “Know what you own, and know why you own it”, and, “Never invest in any idea you can’t illustrate with a crayon.” With these two pieces of advice, Lynch recommended that individual investors get out there and actually use public companies’ products and services before investing hard-earned dollars in those companies. But should you really invest only in what you know?

Funds for every interest

Technological advances in the financial industry have led to the rise of low-maintenance investments based on exchange traded funds (ETFs). What began with plain-vanilla index-based funds, like those tracking the S&P 500 or U.S. financial sector, has exploded into more extravagant options reflecting a wide range of interests. Here are some examples:

• Self-proclaimed spirits connoisseurs can buy shares of the Spirited Funds/ETFMG Whiskey & Spirits ETF (NYSE:WSKY), holding investments in Diageo, Pernod Richard, and Thai Beverage.

• Drone hobbyists might invest in the FactorShares Trust PureFunds Drone Economy Strategy (NYSE:IFLY), focusing on drone technology’s commercial applications (think real-time soil analysis and surveying large construction projects).

• 3D printing enthusiasts can own shares in the the 3D Printing ETF (BATS:PRNT), holding investments in both household names like HP and under-the-radar companies like Groupe Gorge.

Following the “invest in what you know” mantra, somebody who belongs to several 3D printing clubs, owns his personal 3D printer, and is pretty skilled at estimating the price of popular pieces could take the plunge and invest in the 3D Printing ETF – or even directly in Stratasys (NASDAQ:SSYS) and 3D Systems (NYSE:DDD), the largest publicly traded companies in the industry. Buy what you know, right?

Lynch’s advice gets lost in translation

It’s not that easy. Words of wisdom tend to be twisted over time – for example, the famous parable, “Money is the root of all evil,” was actually written in the Bible as, “The love of money is the root of all evil.” And this is exactly what has happened to Lynch’s advice, first published over 20 years ago. It went from “Know what you own, and know why you own it” to “Invest in what you know” because it has a nicer ring to it or makes a better Instagram. While it’s sometimes a good idea to visit a potential investment’s physical locations or try its products firsthand, you should take your due diligence way beyond the consumption level. “I’ve never said, ‘If you go to a mall, see a Starbucks and say it’s good coffee, you should call Fidelity brokerage and buy the stock,’” Lynch warns individual investors. Instead, he recommends reading key financial statements like balance sheets and income statements, listening to earning calls, and reading annual (Form 10-K) and quarterly (Form 10-Q) filings with the U.S. Securities and Exchange Commission (SEC). “If you can’t understand the balance sheet, you probably shouldn’t own it,” concludes Lynch.

The right way to “know what you own, and know why you own it”

Just purchasing products and services isn’t enough to help you identify good investments. You should also take a look at the financial implications of owning individual stocks or funds tracking a basket of equities. Here are some key strategies to keep in mind.

Distinguish between fads and long-term trends

The last thing you want to is invest your retirement savings in something that becomes obsolete in just a few years. Of the 2,270 niche ETFs launched in the past decade, about 16% of them have disappeared. Among those casualties are the Oklahoma ETF (focused on Oklahoma-based companies and closed on September 2010) and the Global X Fishing Industry ETF (focused on fishing industry and closed on February 2012). Keep in mind your target retirement age, and select companies that are highly likely to be around until then. As Warren Buffett recommends, “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.”

Beware niche ETFs with higher fees

Specialty ETFs often charge higher fees than larger and more diversified ones. For example, the 3D Printing ETF has an annual expense ratio of 0.66% (as of September 2016), while the BlackRock’s iShares S&P 500 fund’s is just 0.04%. This means that if you were to pluck $10,000 into the 3D printing ETF instead of the S&P 500 ETF, you would pay an extra $62 in fees per year. Assuming a holding period of 20 years and an annual rate of return of 5%, you would miss on out on an extra $2,105 during the 20-year period.

Think of potential liquidity issues

Don’t expect niche funds to be as easily traded as larger funds. Almost 50% of those 2,270 niche ETFs launched in the past decade had under $50 million in assets. By comparison, the iShares Core S&P 500 ETF had over $91 billion in assets (as of December 2016). More money under management means it’s easier to clear a purchase and sell order; fewer assets mean you may have trouble buying or selling shares.

Know your risk tolerance

Pouring your funds into a single specialty stock can be a wild ride. Take 3D Systems (NYSE:DDD). It traded at $9.51 per share on January 1, 2011, peaked at $92.93 on December 1, 2013, and fell back down to $14.69 on December 1, 2016. That’s quite a bit of movement for your 401(k)! If you’re the type to pull your money during a downturn or increase your holdings when share prices rise, you should avoid investing in high-variance stocks like these. Your age also impacts your investment strategy. Generally speaking, younger investors can be more aggressive, since they won’t need their money in the near future and can weather potential slumps. Older investors should be more conservative, in case their retirement coincides with a downturn.

Don’t put all your eggs in one basket

Proper diversification is critical to any successful portfolio. When considering an investment in a single company or specialty ETF, limit the funds allocated to that investment. Depending on your risk tolerance and retirement saving strategy, financial advisers recommend allocating between 5% and 20% to a particular type of investment. Investing under 5% may be impractical because some funds have minimum dollar requirements, and investing over 20% may expose to the high volatility of certain investments (think of 3D Systems!).

A note for startups

This is closely tied to the point above. Startup employees are often doubly “invested” in the technology sector, and specifically in one company — their own. When both your salary and your investments hinge on the future of one company, you’re exposing yourself to a lot of risk. You may think that as an employee of a company, you can accurately assess its chances of success. After all, you know its inner workings, its profit margins, and its employees personally. However, be wary of personal biases! You’re more likely to think that your “baby” is destined for success but the truth is that 90% of startups fail. Be sure to diversify to protect your assets in the years to come.

Evaluate other available index fund options

Think outside the equity index fund box and review low-cost index funds that invest in a pool  of U.S. small- and mid-cap companies, international stocks, bonds, and real estate. Most index funds provide diversification, have low expense ratios, and may offer that additional exposure to niche holdings that you’re seeking. For more information, read Beyond Equity Index Funds: Bonds, International Stocks, and Real Estate.

Read prospectuses and financial statements

It’s important to review your investments’ financial documents, whether you access them through regular mail or an online portal. “Although it’s easy to forget sometimes, a share is not a lottery ticket…it’s part-ownership of a business,” Lynch reminds individual investors. As a shareholder, you can cast your vote and shape the direction of the companies that you hold investments in. Reviewing the objectives and performance of your investments is an important part of the “know what you own” strategy. Once a year and after a special life event, such as marriage or birth of a child, use the prospectuses and financial statements to check whether or not your current investments continue to match your retirement saving strategy. That said, don’t overreact – withdrawing your money after every down day or pouring more money into companies on the upswing will eventually be less profitable than staying the course.

The bottom line: Do your homework!

The “natural investor” who can somehow sniff out high returns is a myth. That’s why you need to perform your due diligence with your investments. Otherwise, Lynch explains, “that’s gambling and it’s not good.”