Recently one of us was talking to a financial adviser from a medium-sized town in the South.
A fried chicken restaurant in the town, a favorite among locals, had just announced plans to expand regionally with the ultimate goal of becoming the next Shake Shack or Chipotle. The adviser’s phone was ringing off the hook with requests from his clients to invest in the venture. When he attempted to explain to them the complexity of the restaurant industry and the incredible risk associated with such an investment, he was met with a common refrain: “How can this go wrong? The chicken is so crispy and delicious.”
His clients’ enthusiasm makes a certain intuitive sense. One of the most common pieces of financial advice we hear is to “invest in what you know.” The advice is rooted in the philosophy of famed investors like Berkshire Hathaway’s BRK.B, -0.83% Warren Buffett, who has attributed his success to staying within his “circle of competence.” As the chicken example suggests, lay investors often misinterpret and misapply the philosophy, confusing a vague feeling of understanding with the fundamental research that Buffett and others are advocating.
Peter Lynch, another investor closely associated with the philosophy, recently lamented, “I’ve never said, if you go to a mall, see a Starbucks SBUX, +0.67% and say it’s good coffee, you should call Fidelity brokerage and buy the stock. … People buy a stock and they know nothing about it.”
Conflating issuesNew research of ours, forthcoming in the Journal of Marketing Research, sheds light on why people are so apt to misunderstand the “invest in what you know” philosophy: People tend to conflate their sense of understanding of what a company does with the risk of investing in the company. 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.
In a first series of studies, participants read company descriptions of all companies in the S&P 500 Index SPX, +0.40% These descriptions include information about what the companies do, what its major lines of business are, where it is headquartered, who the CEO is and so on. We asked people to rate how well they understood what the company does and also asked them to rate how risky it would be to invest. Companies rated as easier to understand were rated as substantially safer. But when we collected data on the actual risk of the companies such as measures of volatility and rate of return, the easier-to-understand companies were no safer.
We also measured people’s risk perceptions in a more precise way, by asking them to make numerous guesses about how the stock would perform over the next year. People predicted that easier-to-understand companies would perform better and their guesses also fell within a narrower range, suggesting they thought performance was more predictable. Again, neither of those beliefs was borne out when we looked at the actual risk data.
In another study, we manipulated company descriptions to make them easier or harder to understand by changing the order in which information was presented. Despite judging the exact same companies, our participants thought they were riskier to invest in when the descriptions were harder to understand.
In a final study, we asked people to play the role of financial adviser and pick a portfolio of stocks for two clients. One of the clients was young and aggressive with a large appetite for risk. The other was older, close to retirement and risk averse. The participants were able to pick from a group of stocks, some that were rated as easier to understand and some that were rated as hard to understand. We also gave them additional information such as analyst ratings and charts of past performance. Regardless of the true riskiness of the stocks, our participants allocated more of the portfolio to easy-to-understand companies for the risk-averse client, and more to the hard-to-understand companies for the risk-seeking client.
Experts fall for it tooWhat was particularly interesting about this study is that, in addition to testing investing novices, we also tested experienced investors in an online investing community where people discuss strategies, share stock picks and analyze portfolio results together. These people actively trade at least weekly and hold over $100,000 in assets in their portfolios, with some managing millions in assets. Those experts showed the same effect, allocating more to easy-to-understand companies for the risk-averse investor. 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.
Why do people do this? We believe it comes from our natural tendency to use understanding as a guide to risk in other domains of life. If I do not understand something, say, a wild animal or a new contraption, it makes sense to be wary. 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.
So what should you do with this knowledge? We believe the key is being realistic. As lay investors, the radius of our circle of competence is essentially zero. Most of us do not have the expertise and resources to do real research. Put your money in highly diversified assets that provide a 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.
This article is based on “Circle of Incompetence: Sense of Understanding as an Improper Guide to Investment Risk,” forthcoming at Journal of Marketing Research, written by Andrew Long (University of Colorado-Boulder), Philip Fernbach (University of Colorado-Boulder) and Bart De Langhe (ESADE — Ramon Llull University).
