Over the labor day weekend, I picked up a copy of “The Tao of Warren Buffett,” a collection of quotations and aphorisms on investing and business spoken by Warren Buffett himself. It's an extremely quick read because many of Buffett's quotes are short and easily digestable.
Another great feature is that one single quotation can provide true understanding of how the general investment world operates, and why you should stick to investing in what you know. If you invest in what you know, you vote against broad diversification of assets.
Your Circle of Investing Competence
Investment must be rational; If you don't understand it, don't do it. – Warren Buffett
Some Investors will laud strong earnings from Apple's iPod sales, yet most lack the competence to fully understand how Apple operates, makes money, and manages its business. It's nothing to feel ashamed of, either. We all carry different levels of expertise; Some know technology, while others know aerospace.
Uniqueness is what makes this planet interesting, but foolishness causes investors to lose their shirts when buying stocks in companies they do not understand.
Your personal circle of competence differs from everyone else because each of us choose a vast range of activities to occupy our time. Since humans naturally are attracted to pleasureful environments & situations, simply identifying how you spend free time will help pinpoint your personal strengths.
For example, I spend my free time:
- Surfing the Internet
- Managing Assets & Business Systems
- Socializing w/ Family & Friends
- Catching ZZZZss
My free time activities translate into knowledge within the following investment sectors & industries: retail, software, internet, media, publishing, ecommerce, finance etc.
By analyzing your own personal activities, you can highlight your strengths & work on developing an investment portfolio that addresses your strong points.
Jobs & Educational Backgrounds Bring Out Untapped Expertise
Did you ever work a job that seemed pointless to you? Perhaps you previously worked as a McDonald's employee, yet decided your expertise as a restaurant employee would serve no future purpose.
Don't sell yourself short! A McDonald's employee would be much more familiar with the restaurant industry than your Average Joe. Why not put your acquired knowledge to good use and invest within the restaurant industry?
Your job & your expertise are two separate entities. Jobs will come and go, but acquired knowledge within an industry can make you very rich in the long run if you invest wisely and wait patiently.
Why Broad Diversification is the Antithesis of Sound Investing
Diversification is a protection against ignorance. It makes very little sense for those who know what they're doing. – Warren Buffett
Now that you discovered a few of your personal strengths, you can understand why broad, mindless asset diversification makes little sense to the intelligent investor.
In the past, I invested in trucking companies, clothing retailers, and electronic device makers for the sake of diversification.
While my intentions of wide diversification across various industries would please many personal financial advisors, it did not make me richer or satisfy my investment needs. So you guessed it; I sold off my holdings at a loss because these investments were outside of my circle of competence.
Preservation of Capital is Different from Investing
When I hear financial advisors recommend over 18 different investment classes to their clients, I cringe and run the other way.
What are the chances of my understanding 18 different investments? One who carries many investments advocates intense preservation of capital, which is fine, but most people would benefit far more by understanding each investment rather than buying into investments for the sake of diversification.
Of your stocks, bonds, REITS, commodity, and cash investments, it's a good idea to understand each and every investment and watch them constantly. Trusting your money to your financial advisor doesn't cut it anymore. Why? Because your advisor will invest in what he or she knows, and if he or she knows very little, your capital is in big trouble.
The Moral: Invest in What You Know
Some readers will vote against my belief in investing in what you know because they believe broad diversification is the best defender against risk. If all you need is broad diversification to sleep well at night, then sell all your stocks and buy index funds. You are guaranteed to make money in the long run, and you won't lay an egg over everyday stock market events.
For those who continue to own stocks, view your stock portfolio and ask yourself this question: Do I understand every business I own? If you answer maybe or no to any of your stocks, sell off that position and reinvest the money into a business you understand.
Years later, you will appreciate your portfolio and call yourself a genius. And all you did was invest in a sure thing: your personal knowledge & expertise.