“Never invest in a business you cannot understand” – Warren Buffett
You would imagine that the common sense to do is to invest in things you understand and can probably explain clearly to a fifth grader, unfortunately, it so happens that every day, many people are putting their money into things they do not understand.
This doesn’t mean you have to be understand programming to invest in a technology business, but you should endeavour to have an understanding of how the business makes or intends to make money. Neither does it mean that you have to understand complex valuation models to invest in stocks, but you should have a basic understanding of factors that influence share price movements.
The thousands of people who got their fingers burnt in the 2008 stock market crash are an excellent example of this type behaviour. Most were first time investors, who had no idea that the market moved in cycles, alas, it didn’t continue on the up and up forever. Worst still, many didn’t bother to pay attention to the financials of the businesses they were investing in.
Often, when people buy shares, they lose sight of the fact that they have just bought a piece of a real company and not just some piece of paper or an electronic entry. The long-term performance of that stock is closely tied to how well the company does (not just in terms of popularity but financial performance). As such, since you aren’t likely to invest in a private business without taking a look its cash flow, sales, profits and debts, the same ought to be done when buying a company’s stock.
In other words, before buying a stock, identify well-run, growing companies that you understand what they are into. Also, you should understand the company’s business model and the various risks and opportunities it faces. Importantly, this does not require accounting or financial expertise. All you need is basic maths and keen eyes.
However, if you still think it’s all over you head, you need not be scared of the stock market. By investing in mutual funds, index funds, ETFs or even a broad portfolio of stocks, the risk of not understanding your investment can be mitigated through the power of diversification.
In a general sense, investing in what you understand would keep you away from Ponzi schemes like MMM. If you cannot explain how an ‘investment’ generates the cash to pay the returns it pays, then it’s most likely a scam and should be avoided.
In conclusion, just as Billionaire Wall Street investor Warren Buffett admitted, following this rule resulted in missing opportunities to invest in Google and Amazon. In the same vein, this rule would definitely result in some missed opportunities, but it will also prevent you from making some big loses. So you missed couple ten baggers but you have some five baggers and avoided some wipers, still you win.