Invest in what you know - it's a common financial advice investors often hear from their advisers. The advice seems simple at first glance, but it is often misunderstood and many investors end up exposing themselves to risks as a result.
In a think piece on Market Watch, industry watchers Andrew Long, Philip Fernbach and Bart De Langhe shared their research on why people are so apt to misunderstand the philosophy of 'invest in what you know'.
They explained that most people tend to believe that their understanding of a company is the same as their grasp of the risk associated with investing in it.
"When we think we understand what a company does, like making great chicken, we judge it to be a safer investment. Unfortunately, people’s sense of understanding of what a company does is completely worthless as a guide to actual risk, meaning that relying on it is an unwise investment strategy," the trio said.
In their research, they instructed participants to read company descriptions of all companies in the S&P 500 Index. They found out that, of those surveyed, people tend to claim that companies are substantially safer to invest in if they are easily understood.
"People predicted that easier-to-understand companies would perform better and their guesses also fell within a narrower range, suggesting they thought the performance was more predictable. Again, neither of those beliefs was borne out when we looked at the actual risk data," the researchers said.
To substantiate their claims, they tried manipulating company descriptions. Even after the alteration participants believed companies that were harder to understand were riskier to invest in.
This thinking was also apparent amongst some industry experts. The study tested experienced investors in an online investing community and found out that they allocate more to easy-to-understand companies on behalf of risk-averse investors.
"The only difference from the novices is that they allocated a lot more to the easy-to-understand companies overall. This probably reflects how ingrained the “invest in what you know” philosophy has become among expert investors. Ironically, even the experts misinterpret the advice," they said.
The trio surmised that this happens due to the natural tendency of humans to use understanding as a guide to risk.
"The problem is that we often think we understand things when we do not; for instance, when we focus on a restaurant’s delicious chicken but neglect the complexities of the business. That error will cause us to take on more risk than we intend and can lead to major trouble," they said.
To avoid falling victim to this mentality, they suggested being realistic, given that most beginners do not really have an expertise and resources to do research.
"Put your money in highly diversified assets that provide the desired return over time. The challenge is sticking to this strategy. The sense of understanding is alluring and it is easy to be drawn into the trap of thinking we understand things better than we do. Now that you know about this trap, you know how to avoid it," the researchers concluded.