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Investing: "Buy what you know" is a bad strategy

Peter Lynch was one of the most successful mutual fund managers we've seen. One of his strongest pieces of advice was to buy what you know. In fact, the title of one of his books was "One Up on Wall Street: How to Use What You Already Know to Make Money in the Market." But is this actually good advice? The authors of the recent study, "Do Individual Investors Have Asymmetric Information Based on Work Experience?," put this theory to the test.

The goal of the study was to see if individual investors preferred "professionally close" stocks (meaning stocks of companies in fields related to their profession) and if they could outperform a benchmark essentially by buying what they know. The study also looked at the performance of investors buying stock of the companies they work for, as well as other companies near where they live. The following is a summary of their findings:

  • Individuals failed to diversify their human capital, overweighting stocks in their industry of employment.

  • Individuals didn't earn abnormal returns when trading professionally close stocks. On a one-year level, a portfolio of stocks related to investors' areas of expertise had a negative alpha of about 5 percent (meaning investors performed worse than the benchmark). Also, the stocks they sold outperformed the stocks they bought by about 4 percent annually.

  • Individuals traded excessively in professionally close stocks, showing that investors felt more confident trading stocks of companies they knew.

  • Advanced degrees didn't provide any benefit. Those with a Ph.D. didn't generate abnormal returns.

  • Local proximity provided no advantage.

The authors concluded: "Our findings are consistent with both familiarity and overconfidence being the behavioral driver behind our results."

Peter Lynch advocated buying what you know. And research into human behavior demonstrates that people prefer to bet in a context where they consider themselves knowledgeable or competent rather than in a context where they feel ignorant or uninformed. Unfortunately, as Gary Belsky and Thomas Gilovich, the authors of "Why Smart People Make Big Money Mistakes," noted: "For every example of a person who made money on an investment because she used a company's product or understood its strategy, we can give you five instances where such knowledge was insufficient to justify the investment." The results shown above demonstrate that Belsky and Gilovich got it right.

The findings from this new study provide clear evidence of behavioral biases in the investment choices of individuals and add to a large body of evidence demonstrating the general tendency of investors to hold stocks of their employers and other companies they feel they know. Unfortunately, this goes against one of the principles of portfolio theory -- diversification is the only free lunch in investing, so you might as well eat a lot of it. Keep these findings in mind the next time you're tempted to invest in what you think you know.

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