Should You Buy Only Stocks You Understand?

Like many good questions, the answer to the question posed in the title is yes, but also no.  Let's elaborate.

Before we start, we assume that you have decided to hold some individual stocks in your portfolio, and that is a good choice for your financial situation.  That decision is a whole question in itself, and not a simple one to answer, and we will deal with in a future post.

Perhaps Warren Buffett is the best known proponent of the idea that you should only invest in what you really understand. Indeed number 7 on a list of Buffett investing quotes is "Never invest in a business you cannot understand."  Berkshire Hathaway Inc. invested mainly in big name companies operating in areas that he understood. Also, while others were rushing into technology stocks, Berkshire Hathaway Inc. stayed largely on the side (although recently holdings of Apple have been significantly increased).

It seems obvious that you should really know a company before you invest in that company.  No matter how many balance sheets you examine, how many analyst reports you read, it might be argued that you must understand the field the company operates in to truly understand it at the deepest level. It is only through that knowledge that you can reasonably predict how the company's financial situation is likely to change in coming years. Do you really understand fuel cells at a scientific and engineering level, if not why are you considering buying stocks of Ballard? Do you really know the pharmaceutical industry? If not, why are you considering Valeant?

So let's say you  have extensive work experience and academic background in the banking business.  You understand banks and insurance companies at a deep level.  More than any other area of the stock market, you feel qualified to choose which companies have a bright future, and which not so much. Indeed as Alexander MacDonald has pointed out, if you had invested only in Canadian Banks you would have out performed an other North American sector over the past 25 years.

The problem with that approach, however, is that it totally lacks in diversification, and therefore your investment portfolio is expected to be more volatile. A second possible problem is that you might depend too much on your personal expert viewpoint, and not give sufficient weight to the views of investment analysts. The 2008 financial crisis emphasized this point.

However, it is important to think about diversification across your entire financial holdings.  For example, if you have TFSA, RRSP and unregistered accounts, it is not necessary that each be fully diversified, but rather that in total your holdings are. There may well be tax reasons why your holdings in unregistered are different than in the RRSP.  The fact that TFSA accounts are not part of international tax treaties means that certain types of holdings should not be held there (more on that in a future post).

So back to our question on stocks.  If you do decide to hold a number of stocks in one or a few categories, because that is what you understand well, make sure that you balance that with broad holdings in the rest of your portfolio. Not only should no one stock represent a large part of your portfolio, but also no stock category should be a major part.

Some will work in companies where stocks in the company are either part of your compensation, or offered at an attractive price.  While it makes sense to hold those stocks, make sure that it does not represent all or most of your investment holdings. There is a good article on this topic by Eric Rosenberg here.

What are your thoughts on this topic?  Why not leave a comment?  As always, thanks for reading!

This posting is intended for education only and should not be considered investment advice. The reader is responsible for their own financial decisions.  The writer is not a financial planner or investment advisor, and reading this column should not be interpreted as obtaining individual financial planning or investment advice. For major financial decisions it is always wise to consult skilled professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  The author of this column has not received any compensation from any financial company for writing this column, and has no association with any company mentioned.  I do hold a small number of individual stocks, but neither of the two mentioned by name in this column.