What are the risks associated with making investments in what you don’t really understand? Let’s explore.
Just prior to its 2004 Initial Public Offering (IPO), Google (now Alphabet) approached Warren Buffett, the chairman of Berkshire Hathaway. They were looking for a strong endorsement and presence of a marquee investor.
Nevertheless, the legendary investor let go of the opportunity as he didn’t understand how the company would produce a profitable and sustained competitive advantage over its peers. Google went on to become the third-largest company by market capitalization.
”Never invest in a business you don’t understand” is the famous Buffett rhetoric. And true to his word, he stayed away from technology stocks like Google and Microsoft.
He was okay losing out on such an opportunity rather than exposing his investors to the risk of investing in something which he didn’t comprehend.
Many renowned investors have a similar approach to stock-picking. Legendary fund manager Peter Lynch, for instance, believes that the more familiar you are with a company and understand its business and competitive environment, the better the chances of finding a ‘story that will come true.
So, if you are a stock picker, and find business models of new-age companies into cloud computing or biotechnology difficult to fathom, steer clear of it.
Perils of familiarity
Also, don’t get sucked into the ‘intuitive’ trap. Just because you frequently shop in a retail chain, you might get lured by its prospects. You start reading stories on the great Indian consumption story – a confirmation bias – to affirm your belief.
Indian consumption is a big opportunity indeed. A lot, however, depends on how the company capitalizes on the opportunity. Moreover, even if it is doing well, its share price might have run up to give you any value.
Similarly, avoid penny stocks that often don’t disclose much about their business. Poor accounting practices, corrupt management, and price rigging are not so uncommon among them. For every penny stock that doubles, there are many others that have sunk into oblivion.
When analysts choose stocks of companies, they scrutinize their business model. And if it is about commodities like gold and metals, they look at its demand-supply situation to forecast its prices. How do you do it for Bitcoins and other cryptocurrencies?
While the crypto traders cite limited Bitcoin supply (of 21 mn) and its increasing demand to forecast high prices, there are lots of other factors.
Bitcoin prices crashed recently when Tesla pulled out of Bitcoin-related payments for its electric car and China put a stop to bitcoin mining within its borders.
With lesser knowledge of cryptocurrencies and their extreme price volatility, retail investors are better off sitting on the fence.
Role of mutual funds
When an investor picks up a mutual fund, there are several categories to choose from. For instance, there are several categories under equities, debt, and cash. While the ones like that of large cap, mid cap, and multi cap are easier to understand, there are also the niche ones like that of arbitrage, smart beta, and ESG funds.
Retail investors are better off investing in funds that they can understand. If you are hiring a financial advisor, you can invest in investment products that you understand little about, as long you are familiar with its risk-return characteristic.
However, if you find it too complex, follow the commonsensical rule of keeping investments simple.
Most investors are always better off choosing investments that are simple and easy to comprehend. This makes it much more likely that you will stick to an investment plan and achieve your financial goals.