Why You Need to Invest In What You Know

You shouldn’t put your money in investments you don’t fully understand.

By SHARE

I can't think of anyone better to look to for investment advice than Peter Lynch or Warren Buffett. Lynch and Buffett are legendary investors who have amassed billion dollar portfolios through sound investment strategies, one of which I want to share with you today.

Peter Lynch, the legendary portfolio manager from Fidelity, is famous for offering the advice, "invest in what you know." Famed investor Warren Buffett often refers to investing within his "circle of competence" when discussing how he and his partners invest. "Circle of competence" may not mean much to you, but what Mr. Buffett is really stating is, "invest in what you know."

[See 10 Costs That Could Increase in Retirement.]

Buffett and his partners famously sat out of the Dot-com Bubble in the late nineties because technology wasn't a field he was comfortable with. While others speculated on technology start-ups, Buffett was scooping up value stocks which had fallen out of favor. A few short years later the bubble crashed and investors went back to the value stocks Buffet had been buying all along. Buffett not only avoided substantial losses, but he made money because he stayed true to investing in what he knows. The idea of investing in what you know is not a new concept, but it is worth repeating because it is solid advice and can help you avoid serious investing mistakes.

Only invest in what you know and understand. Anyone can learn to read a balance sheet and perform basic stock analysis. But if you don't understand how a company generates income and profitability,  who their main competitors are, and the risks and opportunities in the field, then you shouldn't own their stock.

[See Your 401(k) is Not a Savings Account.]

The same concept can be applied to different types of investments. Many people understand the basics of stocks, bonds, mutual funds, and Exchange Traded Funds (ETFs). But how much do you know about trading stock options, Forex, derivatives, commodities, binaries, or other more complex investing methods? If you don't know how an investment works, don't buy it.

Knowledge is an investor's best friend. Knowledge gives you a competitive advantage, which is essential when you have your money on the line. It also gives you the confidence to make educated investment decisions and the ability to react more quickly to changing situations. It is difficult to adjust your investment portfolio when you need to constantly research the fundamentals of your holdings.

What you don’t know can hurt you. You are playing with fire if you are investing your money in a business or investment method you don't fully understand. Unknown information increases the likelihood you will make more investing mistakes. The unknown can also set you up for scams.

[See 6 Ways to Disaster Proof Your Retirement Plan.]

Investment scams have been around since the dawn of civilization, but no era has ever seen the proliferation and complexity of the investment scams that are around today. These new scams are becoming more difficult to detect, especially when you are dealing with a type of investment with which you aren't familiar. Remember, there are no shortcuts, especially when it comes to making money. The best way to avoid these scams is to stick with trusted financial partners and investments you understand.

Invest in what you know. There are numerous reasons to stick with what you know. It is easier to maintain a proper asset allocation when you understand your holdings. You will also sleep better at night, enjoy investing more, and be more likely to avoid serious investing mistakes or scams.

Ryan Guina is a U.S. military veteran, writer, and professional in the corporate world. He blogs at Cash Money Life and The Military Wallet.