Investors often embrace advice from accomplished professionals to, “buy what you know.” Legendary fund manager Peter Lynch and investing icon Warren Buffet have both advocated purchasing stock in companies whose businesses you understand. Trying to execute this strategy, however, can prove to be a risky and unprofitable endeavor for investors that take an unsophisticated approach.
What Does it Mean to Understand a Business?
Some businesses can be understood more intuitively than others, but familiarity should never be a substitute for due diligence. What often separates professional investors from individual investors are attention to detail and a focus on valuation. Many investors fail to appreciate the level of detail that successful professionals require in order to understand a business. An investor that purchases Sony stock because he is pleased with his Sony TV purchase may be ignoring important risks associated with the company’s business, such as high labor costs that contribute to losses in consumer electronic sales.
Peter Lynch, a former mutual fund manager who compiled one of the most impressive track records in the industry, is well known for encouraging investors to harness the “power of common knowledge” by buying stock in companies that produce goods and services that you are personally familiar with. Lynch drove a Volvo and bought stock in the company; and he was a fan of Dunkin Donuts coffee and also bought that stock. Lynch, however, did not generate impressive returns by simply buying companies whose goods he purchased. He would meticulously analyze company filings and financial statements to learn as much detail as possible about the company’s business and its valuation.
Familiarity Should be a Starting Point, Not an End Point
While it can make sense to use the “power of common knowledge” as a starting point, investors should resist the temptation to substitute familiarity for due diligence. Familiarity with products, in and of itself, is not a good reason to purchase stock. If familiarity leads you to a company that, after thorough analysis, appears to be a well-managed business with sustainable competitive advantages and favorable valuation, then you may want to seriously consider buying the stock. But buying a company like Coca Cola just because you like their beverages is not a good strategy. Warren Buffet is well-known for investing in Coca Cola stock, but he did not invest just because he likes Diet Coke. Buffet bought Coca Cola because the company sells products in nearly every country, has sizeable profit margins, and is able to charge a premium for its products because consumers are hesitant to shift to a competing brand.
Exercise Caution with Your Company’s Stock
Confusing familiarity with due diligence is always dangerous, but can be even more hazardous to your wealth when familiarity with the company you work for prompts you to allocate a large portion of your portfolio to your employer’s stock.
In fact, holding too much stock of the company you work for is one of the most dangerous strategies for an investment portfolio. Many people feel that investing in their own company’s stock makes sense because it is the company they know best. The reality, however, is that far too many investors hold far too much of their employer’s stock.
At the most basic level, investing a large portion of your portfolio in your own company’s stock leads to very poor diversification. Your employer is the source of your income. If you make your employer the source of both your investment returns and your income, your personal finances are disproportionately dependent on the success of one company. Should your company’s business take a turn for the worse, you may be hit with the unpleasant combination of investment losses and job loss.
Not very many investors think their company will fail or deliver investment losses, but it happens all the time. In 2004, March and McLennan, the large insurance brokerage firm, was charged with insurance fraud. Over $1.2 billion in company stock was held by employees in retirement plans, and the fraud charges caused the price of the stock to plunge 48% in four days. The result was that more than a half billion dollars in retirement funds was wiped out. Over the next six months, Marsh laid off 5,500 employees, many of whom remained jobless for an extended period with a retirement fund that had been cut in half.
Tying both your income and your investment portfolio to one company is a very risky proposition. Professor Lisa Meulbroek of Claremont McKenna College estimates that a 50% allocation to your employer’s stock over ten years is worth less than 60 cents on the dollar after adjusting for risk. And the risk adjusted value of just a 25% allocation to your employer’s stock is only worth 74 cents on the dollar.
Think about other aspects of your personal finances. Your home is not likely to burn down, but it remains prudent to protect yourself with homeowner’s insurance. Your company will probably not be the next Enron, Washington Mutual, or Lehman Brothers but you should still insure against the possibility of catastrophic investment losses coupled with job loss by placing a limit on your allocation to company stock. Diversification is simply not optional. Many financial planners recommend keeping 5% or less of your portfolio invested in your own company’s stock, and under no circumstances should company stock ever exceed 10% of your portfolio.
If you need help diversifying away from your company’s stock or conducting due diligence on familiar companies, consider consulting a CERTIFIED FINANCIAL PLANNERTM professional from the Financial Planning Association with the experience and expertise necessary to guide you.
FPA member David Zuckerman, CFP®, CIMA®, is Principal and Chief Investment Officer at Zuckerman Capital Management, LLC in Los Angeles, CA. He serves as CFP Board Ambassador and Director at Large for the Los Angeles chapter of the Financial Planning Association.