It is always tempting to buy stocks that are popular, exciting or may have a positive influence on people’s lives. For example, some investors may focus on investing in industries such as artificial intelligence or health care because of the difference companies operating within them could have on people’s quality of life or life expectancy.
However, in my opinion, this is a dangerous strategy for many investors to pursue. They may not understand such industries and could fail to determine which companies have long-term investment appeal. For example, they may not have detailed knowledge of how artificial intelligence works or how the drug approval process is structured. This may mean they end up overpaying for their holdings or, worse still, they purchase unattractive businesses that go on to deliver poor returns.
This viewpoint has previously been highlighted by Peter Lynch, who generated a 29% annualized return between 1977 and 1990 when running the Magellan Fund. As he once said, “Most great investors I know (Warren Buffett (Trades, Portfolio), for starters) are technophobes. They don’t own what they don’t understand, and neither do I.”
A sphere of knowledge
I think that Lynch’s views are extremely relevant to all investors. A possible solution is to stick to industries in which an investor has detailed knowledge. This will ensure they understand all the companies operating within it and are able to select the most appealing risk-reward opportunities. The end result is likely to be a far more efficient allocation of capital than investing in companies they do not fully understand.
Of course, it takes time to build detailed knowledge. And no investor can fully understand the ins and outs of every single industry and company. Therefore, in my opinion, it is logical to use index tracker funds to fill the "knowledge gap." For instance, an investor may apportion part of their portfolio to industries in which they have detailed knowledge. They may then buy an index tracker fund with the remainder of their portfolio to provide diversification and risk reduction benefits.
As their breadth of knowledge improves, they may find they become less reliant on an index tracker fund and it accounts for a shrinking part of their portfolio.
A disciplined approach
Clearly, it is difficult to resist the temptation of buying the latest story stock that is making headlines and gaining rapidly in price. All investors naturally do not want to miss out on such opportunities.
However, as with all aspects of investing, it is important to be disciplined and avoid any company or industry that you do not understand. This may mean missing out on a number of excellent buying opportunities that go on to deliver stunning returns.
However, it also makes managing a portfolio far easier. Crucially, investors with detailed knowledge of a specific industry can confidently and decisively react to changing market conditions that may leave many of their peers in a state of panic.
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