Many years ago, pop singer Barbra Streisand told Fortune Magazine that she invested a part of her wealth by herself. When asked where she got her ideas, Ms. Streisand replied that they came from relatives, friends and daily life. "We go to Starbucks every day, so I buy Starbucks stock," she added.
This is the "buy what you know" approach, where an investor buys shares in companies whose products are attracting crowds at the mall, or getting rave reviews from friends and relatives. Having talked to a number of investors for the Globe and Mail's Me and My Money column, I can attest that the strategy is still in vogue some two decades after mutual-fund star Peter Lynch wrote his seminal book, One Up on Wall Street: How to Use What You Already Know to Make Money in the Market. But as Mr. Lynch cautions, there is more to it than just shopping trips and chit-chat.
Like reviewing company financial reports and other sources to answer some key questions. Is the balance sheet strong? Is there something about the company's product that rivals find hard to replicate? Has the stock price run up to the point of overvaluing growth potential? Is accounting artistry putting a gloss on earnings? And so on. In short, one wants to buy a good company at a good price, not a company whose growth is about to peak or whose share price is overly inflated.
So there is quite a bit of work to do. Judgements have to be made that require digging through a number of sources. But individuals busy with jobs and family usually don't have the time or energy to do a proper job. It would be better for most people to use index funds, as Mr. Lynch counsels.
Recent academic research suggests as much. The paper, "Do Individual Investors Have Asymmetric Information Based on Work Experience?" looked at the performance of investors buying shares in companies they knew well – the ones they worked for, or near where they lived. According to the authors' findings, buying such investments ended up underperforming the benchmark; after they were sold, they tended to outperform.
READERS: Do you find yourself investing in the products or businesses you know and like?
Larry MacDonald is a retired economist who manages his own portfolio and writes on investing topics. He tweets at @Larry_MacDonald