I disagree with an expert, buying what you know makes sense
A few weeks ago, Larry Swedroe wrote in a CBS News Moneywatch article that buying what you know is a bad investment strategy.
I disagree with that actually.
For those who might now know who Larry Swedroe is, he is the Principal and Director of Research for Buckingham Asset Management and an accomplished author who has published 11 investment books, the most recent one, The Quest for Alpha. He’s a very bright guy, he’s legendary actually. I had the pleasure of meeting Larry last year here in Ottawa. When it comes to passive investing or investing in general, Larry knows his stuff. However, when he made the claim “buy what you know” is a bad investment strategy, I took notice and dared to disagree.
I think buying what you know can be an excellent strategy.
The Moneywatch article I recently read referenced a recent study entitled “Do Individual Investors Have Asymmetric Information Based on Work Experience?” to put the “buy what you know” theory to test. Some of the findings of this study are summarized below (my thoughts follow in italics):
- Individuals failed to diversify their human capital, overweighting stocks in their industry of employment.
I suspect this is not uncommon but this seems more like a diversification issue than a “buying what you know” issue.
- Individuals didn’t earn abnormal returns when trading professionally close stocks. On a one-year level, a portfolio of stocks related to investors’ areas of expertise had a negative alpha of about 5 percent (meaning investors performed worse than the benchmark).
I think a one-year window for investment analysis purposes or to suggest a trend, is a very short window. Actually, the window is barely open to take a decent look.
- Individuals traded excessively in professionally close stocks, showing that investors felt more confident trading stocks of companies they knew.
In my opinion, trading is not investing. Going another step further, I think excessive trading is more akin to gambling. I’m not a financial pro by any means but I believe investing is correlated to making a financial plan and sticking with it. This plan can include stocks, bonds, a savings account, debt repayment or any combination of these.
- Advanced degrees didn’t provide any benefit. Those with a Ph.D. didn’t generate abnormal returns.
Not sure how advanced degrees have anything to do with buying what you know but I can only assume there is a bias to being overconfident because you are a subject matter expert if you hold a Ph.D.
If the findings from the study want to suggest investors have a false sense of security when they invest in the stocks of their employer, I can support that. These individuals may be overconfident owners of their company based on the industry they work in. Yet buying what you know can make great sense as long as you are following good portfolio management practices – buying a diversified set of what you know over time.
Many mutual funds and exchange-traded funds (ETFs) have done this diversification for you, for a fee of course, which makes things much easier since you have instant diversification. To this point, dividend investors have a challenge that index investors do not have, they are taking some risk upon themselves to diversify their portfolio over time.
The following companies have been dividend stalwarts for decades. These companies also comprise the top holdings of many dividend and equity exchange-traded funds (ETFs) in Canada. In the name of buying what you know, I figure if the biggest funds and ETFs in Canada hold these companies, if I’m going to own stocks directly then I should own them too. Here are some examples of what many Canadian dividend and equity funds own as part of their top holdings:
- Major financial companies (TD Bank, Royal Bank, Bank of Montreal, CIBC, Bank of Nova Scotia, Manulife)
- Major energy and utility companies (Enbridge, Suncor, Canadian Natural Resources, TransCanada, Fortis, TransAlta)
- Major telecommunications companies (Bell Canada, Rogers, Telus, Shaw)
If you owned these companies, you might be surprised that through buying what you know, you’d own about 50% of the equities in the TSX by market value.
In closing, I definitely agree with Larry Swedroe that diversification is the only free lunch in investing so you might as well eat a lot of it but buying what you know can make great sense as long as diversification principles are applied. Otherwise, if you’re going to put your eggs in one basket just remember it’s one basket.