Know & Understand%2C Sixth Edition

Article Reprinted from Hemispheres

Peter Lynch once said “Invest in what you know and understand.”  The advice seems all too simple, yet most of us simply ignore it when making investment decisions.  Take a look at your own portfolio.  Do you really know and understand the businesses that those companies are involved with?  Really?  I’d wager that less than one product of investors in Cisco really understand what it is that Cisco does.  I’ve had financial planners, software folks and even engineers explain it to me, and I still don’t really understand what it is they do.

Too many of us invest in things because it is the flavor of the day.  Our broker says we need it, our friends say they have it.  We get caught up in the frenzy.  Now, while markets are falling, do we follow the herd into the slaughterhouse again and sell at a loss or do we stay the course, maybe buy more.  If we invest in what we “know and understand”, then we will know if a company’s valuation is overly high in time of “market exuberance” (a good time to sell) and we will know when a valuation is overly pessimistic as many companies are becoming today (a good time to buy).

A year ago Cisco’s price to earnings ratio was floating at around 200, meaning it would take 200 years worth of the company’s earnings at current levels to equal the price per share that you would have paid to buy it.  Now the P/E is 87. Was it a good buy then?  A good buy now?  I don’t know.  To me the valuation seems awfully high, but then again, I could be completely wrong.  The point is, and I don’t understand the business, so I have no business buying it, even if the P/E falls to 5.

“What Should I Invest In?”

So in asking yourself “What should I invest in?”,  The first answer should be what do I know or alternately, what would I like to know about.  If you don’t know the business or are not prepared to learn the basic fundamentals of the industry, don’t buy.  You don’t have an edge and unless you’re extremely lucky, you won’t make any money.

Now, what is it you already know something about?  For many of us its our businesses.  We invest a great deal of our time and money in our businesses.  Many of the wealthiest people that I do asset protection and estate planning work for have never touched the stock market, preferring to invest all of their spare capital into themselves.  By the time they sold their businesses, or passed them along to children and grandchildren, they had gone from being worth nothing to on average $4.5 million dollars.  Some had amassed tens of millions of dollars.  Regardless of what their business was they understood it well, and they exploited their competitive advantage to create wealth.  So there is the first rule to create wealth, invest in yourself.

If you don’t have a business, invest first in something you would like to be involved in, not merely as a passive investor.  If you like local real estate and “know and understand” when and what to buy, when to leverage and when to sell, you will make a fortune.

Invest in What You Like

If you like gold, oil, natural gas, international real estate, timber or other commodities, get to “know and understand” how those businesses work and who the operators are.  Are they accessible?  Will they answer your questions and accept your thoughts and ideas?  The small ones generally will if they want your investment dollars, larger ones generally can’t or won’t.  If you stay close to the pulse of a small organization, you will be better able to judge whether you should put more money in or be looking to get out.  “Know and understand” must be your guide.  If you have the capacity to know and understand only a few areas, then those areas along with conservative investments such Treasury notes, CD’s, etc., should be how you round out your own balanced portfolio.

Diversify Your Portfolio

If you can understand private placement, some publicly traded stocks and bonds, commodities and real estate, then by all means diversification will help you create a block buster portfolio over time.  To diversify into things you don’t understand however, is like my buying Cisco.  It might work out, but then again it probably won’t.  Your chances of retirement in riches will be much better served concentrating your investment dollars into what you “know and understand” than by following the herds into this investment and then trying to pluck a diamond out of a riverbed of rocks with a blindfold on.