Mutual Fund Monday - Dagen McDowell

Return to Article

Don't Buy What You Know

Dagen McDowell

If you're ever tempted to "buy what you know" in the stock market, repeat these two words: Boston Chicken.

During the early nineties, few people could resist the chain's rotisserie chicken or its sumptuous stock. When the company went public in 1993, the stock shot up more than 140% in one day, and its expansion across the country was seemingly unstoppable. Until of course, the company's accounting turned out to be disastrous. Boston Chicken filed for bankruptcy in 1998, was renamed Boston Market and is now owned by McDonald's.

Good food. Terrible company.

By blindly following a "buy what you know" strategy, you could end up owning lots of expensive, faddish stocks, ignoring a company's underlying problems and assembling a portfolio that's heavily concentrated in just one industry. A company with a great product that you love to buy can still have an pricey stock, lousy balance sheet, tricky business plan and irresponsible -- even corrupt -- management.

The concept of looking for investment ideas in your everyday life is a great starting point. But it's only that: a starting point.

This investing tactic was popularized by legendary fund manager Peter Lynch. The former manager of Fidelity Magellan is probably best known for finding great investments through products like L'eggs pantyhose, which his wife spotted at the grocery store.

But the notion of "buy what you know" can be dangerously oversimplified. Even Peter Lynch tells you that in his book One Up On Wall Street: How to Use What You Already Know to Make Money in the Market. He warns against betting on every hot new business you might encounter at the local shopping center. That book, after all, runs more than 300 pages and has nine chapters devoted to stock research.

For one, by the time you discover some exciting company with an irresistible product, plenty of other people surely know about it as well. And that enthusiasm is probably reflected in the company's stock price.

You could wind up piling your money into an expensive stock. And to justify paying that high price, this company business would have to be that much more successful and grow faster than most other businesses. And if one piece of news surfaces that suggests growth might be slowing, that stock will collapse.

Just look at what happened to Harley-Davidson (HDI) recently. People just love the company's fat, loud motorcycles, but the expensive stock has reflected that adoration for years. Just last week, the company reported a 27% jump in quarterly profits and beat analysts' estimates. But Harley didn't raise its production estimates for the year, which some analysts and investors were expecting. The stock fell more than 12% in two days.

It only takes a little bit of bad news to knock a pricey stock to its knees. Remember that if you're thinking about buying Krispy Kreme(KKD). Yes, its donuts are luscious creations, but everyone already knows that. And the stock shows it. It's about twice as expensive as the broad market. And that's after the stock's 9% drop on Friday.

By focusing too much on buying what you know, you could also wind up with a portfolio that's heavily weighted to just one industry -- say retailing -- or one filled with trendy brands that can quickly lose their luster.

You might not have the necessary exposure in your everyday life to deliver a diversified portfolio. Outside of your job, you probably encounter retailer after retailer -- whether you're buying diapers, books, toys, clothes, furniture or electronics.

Your portfolio could turn into a collection of cyclical companies, which produce products that people can postpone buying, like cars, top-shelf liquor or expensive handbags.

I'm not allowed to own individual stocks as an employee of TheStreet.com. But if I went out and bought a handful of stocks based on my own life, I would wind up with a bunch of high-end apparel companies and a deeply troubled bank stock.

Since I spend way too much of my time pining for pricey clothes that I cannot afford, I would buy Gucci, LVMH Moet Hennessy Louis Vuitton and Polo Ralph Lauren. And I, unfortunately, do my banking at Chase, which is part of J.P. Morgan Chase.

Those luxury-clothing companies have done well over the past year. But fashion in still a fickle business and I should not have the bulk of my money tied to one narrow industry. And J.P. Morgan Chase, struggling to shake off its past dealings with Enron, is still facing weak investment banking business.

My portfolio would lack exposure to so many different industries, from technology to health care and energy.

The same might apply to you. And without doing your own hard-core research on each stock you select, you could end up owning the next Kmart or, worse, Boston Chicken.