Note that this section of the website is not particularly active; I hope to publish about one personal finance article per month.

Saturday, April 12, 2014

The Dangers Of Investing In What You Know

There is a risk associated with investing in areas that you are closely associated - your investments may end up being hurt by negative factors that also hit your employment prospects at the same time. There is considerable amount of analysis of the financial benefits of diversification of the types of investments you own in your portfolio (e.g., owning both stocks and bonds). However, you need to also keep in mind the importance of diversification of your overall risks in life, which is harder to measure. This uncertainty means that one should stress diversification within your financial portfolio.

The famous investment manager Peter Lynch popularised the concept of investing in what you know. However, his examples typically revolved around using information you pick up indirectly. One class of examples he gives is buying the shares in retailers that you like shopping at, and you see it expanding. Retail and restaurants are relatively easy for consumers to evaluate in terms of the quality of the firm, since they have to choose which ones to patronise. (But just because a company is well run, it does not mean that it is a good investment, as the shares may be too expensive.)

This can also include information you pick up at work, but this poses more problems. If you see a customer firm ramping up purchases because it is expanding rapidly, it is a signal to dig deeper to judge whether it is a good investment. But it is riskier if you start buying shares in your employer, or even your industry.

The classic example is the technology bubble that took place in the 1990s. There were a lot of jobs created in information technology, and many of the employees in the sector invested heavily shares of technology companies. When the bubble popped, they were hit by falling prices of shares in their portfolios, while at the same time employment prospects in technology collapsed.

The worst case is where you buy the shares of your employer, and it ends up bankrupt. If you are not in a position to meaningfully shape the success of your employer, putting your personal portfolio into its shares means you have largely lost control of your fate.

And this just does not apply to buying stocks. If you work in an industry that is highly dependent upon home values - for example construction or real estate - it may not make too much sense to have too much of your net worth in housing (your home and/or rental housing). Many Americans have learned this lesson, but I am afraid that this lesson about housing risk has not sunk into Canadians' consciousness yet.

Unfortunately, this is a difficult risk to analyse. People in finance can point to studies of the statistical effects of diversification upon portfolios. It is easy to measure portfolio returns with a statistical package. But it is difficult to relate a portfolio to someone's job prospects. This is a judgement call that has to be made by the individual. An investment advisor may be able to help, but it must be kept in mind that this is not a subject that is heavily discussed in investment training.

Thinking Broadly About Diversification

Given this uncertainty, it adds to the incentive to diversify your portfolio assets.

  • Not having a large part of your portfolio in a single sector - or worse yet, a single investment - is a fairly standard warning. Correspondingly, most of your stock holdings should reflect the broad equity indices, without a significant exposure in sector funds.
  • Be cautious about investing in your employer.
  • Holding international equities reduces the risk associated with a slowdown in your home country.
  • Owning government bonds, despite their unappetising low yields at present, provides some protection against recessions (when you are statistically most likely to lose your job). Government bond prices typically rise as the economy slows. (Note that this advice is harder to apply for many countries, such as developing economies or countries in the Euro area. This is a topic that comes up often in the articles on my main web site,
  • Avoid having too large an exposure to real estate, particularly if you work in an industry exposed to that sector.
  • If you have your own business, you should have enough liquid assets to allow you to weather a rough patch. You should be able to get a better return on the assets in your business than the financial markets (if not, why bother?), so it does not make sense to take too much risk in your portfolio until you have a considerable margin of safety. 

(c) Brian Romanchuk 2014