The next time you're tempted to "buy what you know" in the stock market, remember that 200-pound rowing machine sitting in your attic.
In the past decade, everyone seems to have fallen in love with this investing maxim, popularized by
legend Peter Lynch. The former manager of Fidelity's
Magellan fund is often remembered for finding great investment opportunities from products like
pantyhose, which his wife noticed in a grocery store.
But the concept has turned to gruel through oversimplification.
The notion of looking for investment ideas in your everyday life is a good starting point.
a starting point.
Companies with great products can still have lousy balance sheets, sketchy financing, uninspiring leadership and a dozen class-action lawsuits pending.
If you followed this approach too closely you could have had a portfolio of
. All three of these companies were once popular with consumers. And for various reasons all three ended up filing for Chapter 11 bankruptcy protection.
If you aren't careful, you could wind up with a portfolio that's heavily weighted to retailers or -- even worse -- one that's filled with popular brands backed by bad businesses.
"Most people don't have the breadth of exposure to give them a reasonably diversified portfolio by just buying what they know," says Bill Nygren, manager of the
Oakmark Select funds.
Think about it. You might work for a tech company, but outside of your job, you probably encounter a heavy dose of retailers -- whether they are selling clothes, pharmaceuticals or furniture.
By constructing a portfolio that's filled with retailers, you're heavily invested in some cyclical businesses. A cyclical stock is one that produces products that consumers can postpone buying, like pricey women's clothes or top-shelf liquor.
Going into a recession, people stop buying these goods, which obviously hurts these stocks.
You also may be tempted to buy producers of popular consumer products like
Procter & Gamble
. All of these companies have struggled recently as consumers have become less and less willing to pony up for their name brands.
On the other hand, the tech stocks that have recently ruled the market are not things you'd necessarily encounter at the mall.
, which has rocketed 587% in the past year, makes fiber-optic equipment.
, up 151% over the same period, manufacturers the gear used to connect computer networks like the Internet.
If I went out and bought five stocks tomorrow based on my own life, I would certainly wind up with a heavy allocation to cyclicals. (However, I cannot own stocks as an employee of
Outside of work, I eat, shop and exercise. Since more of my time is spent shopping than eating, my admittedly New York-centric portfolio would be overloaded with high-end apparel and cosmetics companies.
I would wind up buying
, which makes some of my favorite high heels,
Polo Ralph Lauren
, which sells some luxurious clothing and the sheets on my bed, and
, which dominates the upscale cosmetics market in the U.S.
Then, I would have to buy
. I swear by the company's running and exercise shoes using the DMX technology.
Lastly, I would throw in
, my bank. Given Chase's customer service, I might rethink that choice, given more time.
All in all, I would wind up with 80% of my assets in cyclical stocks -- namely apparel companies -- and have no technology exposure.
I love the goods the retailers in my imaginary portfolio produce. But these businesses -- particularly the luxury-goods producers -- would be hurt if a recession hits. Consumers would start removing those Gucci python bags from their must-have lists, and my portfolio would feel it.
Buying a stock based purely on a popular product or service doesn't give you any feel for the company's management or its motivation. You or your spouse might love
clothes but her company has been plagued by poor, revolving management. You'd never know that, though, based on the popularity of her ethereal evening gowns.
Which brings up my next point: As a consumer, you may only be seeing a very small part of a company's business.
"A company could be so big that the product or service that you're aware of isn't a significant enough piece of the entire company that its success of failure drives the economic value of a the company," says Oakmark's Nygren.
You might love
appliances, but that business is relatively trivial in the grand scheme of things. Yes, the company is one of the nation's largest appliance makers but this division only makes up about 6% of the parent's sales.
makes up about 40% of the company's sales.
"You could get swamped by the company's financial services business," says Nygren.
If you have discovered a product and company that no one knows about yet you may be on to a great investment idea. Chances are, however, you might be hitting a trend or a brand at its very pinnacle when a company's stock is its most expensive.
I think one of the biggest contributions to investment return is how the stock is priced at the time you buy it," says Nygren. "If the entry price isn't sensible relative to the business value, you aren't likely to get an acceptable return."
From the abundance of ads,
still seemed popular a few months ago. But at the beginning of April, the company warned that its earnings for the coming fiscal year would be 30% to 40% lower.
Obviously, the idea of "buy what you know" requires a lot more than picking up the companies that sell your favorite coffee, chicken dish and sneakers.
"Buy what you know has a lot more behind it," says Debra McConnell, a Fidelity spokeswoman. "It still means that you need to do your research and your homework before you decide to invest."
If you don't have time to put in the research, put your money in the hands of someone who does, like a mutual fund manager. At the end of the day, most of us know jelly donuts better than semiconductors anyway.
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