Investing in what you know

Investing in what you know

I always tell people that nearly anybody can be a good investor. I do not believe everybody can be a good trader, but anyone can invest successfully, if they follow one general principle: invest in what you know. It sounds simple enough, yet it is very powerful. When pouring over financial data to calculate the "intrinsic value" of a company, can you be certain numbers tell the entire story? When Lehman collapsed, or Satyam went for a toss, were the great financial guru's of the time able to foretell what was about to happen?

Your Circle of Competence

Legendary value investor Warren Buffet terms it your "Circle of Competence". Everyone has certain interests that they know a lot about. This set of interests is what you know best. If you are a car enthusiast for instance, you will follow all the major makes and models that are out on the market today. If you have been following the automotive industry for long enough, you would have your finger on the pulse and be able to tell a good model from a bad one. You will be able to tell when a hit model from a certain company makes it out before even the record sales figures come out. This type of  innate, time accumulated knowledge is what forms your "Circle of Competence". If your knowledge of a certain sector is very, very strong, you would already know which companies are bound to do well, and which counters you would be wise to get out of. Combining this innate knowledge with proper financial analysis of a company/sector can be extremely rewarding.

Warren Buffet never invests in sectors he does not know about. When people were turning into overnight millionaires during the dot com boom, Mr Buffet simply stayed put. The financial community at that time was mocking him for not getting into the then "internet sensations", but Sir Buffet was wise: the internet technology space was not part of his Circle of Competence, and he thus didn't know enough about it and did not want anything to do with it. Very simple logic, yet so powerful if followed diligently.