Don't Buy What You Know

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.