Don't
Just Invest in
What You Know
There
is a common belief in investing circles that you should "invest in what you
know." Warren Buffett calls it an investor's "circle of
competence."¹ The idea is that it's best to invest within your area of
expertise. The more you know about a particular business or industry, the better
your ability to pick a winner.
Business owners sometimes push this advice beyond its usefulness, pouring money into their own
businesses to the exclusion of others. Doing so ignores another commonly
accepted bit of wisdom: diversify.²
If you have the
bulk of your net worth wrapped up in your company, imagine what would happen to
your retirement if the business failed or was worth less than you expected when
it came time to sell.
The Merriam-Webster
Dictionary provides a definition of "diversify" as: "to
balance (as an investment portfolio) defensively by dividing funds among
securities of different industries or of different classes."
One way to help
achieve diversification without being an expert in multiple industries is
through ownership of mutual funds.³ A mutual fund pools money from a group of
investors and constructs a portfolio from individual investments such as stocks,
bonds, or cash equivalents in order to pursue a stated investment objective.
Participation in a mutual fund means you may have an interest in dozens or even
hundreds of separate, underlying investments.
When you purchase
shares in a mutual fund, to some extent you are also buying the expertise of the
fund manager. Fund managers carefully research, select, and supervise all the
assets a mutual fund holds, buying and selling in an attempt to maximize the
fund's return on the basis of its objectives. This allows investors to pursue
potential gains in industries where they may have no expertise.
It's natural to
want to put everything in your business to make it succeed. Taking advantage of
the many benefits that mutual funds offer may help you diversify outside your
business.
1)
About.com, 2003
2) Diversification does not guarantee against loss; it is a method used to help
manage investment risk.
3) There are fees and expenses associated with investing in mutual funds,
including portfolio management fees and expenses and sales charges. Mutual funds
are sold by prospectus only. Be sure to read the prospectus carefully before
deciding whether to invest. The return and principal value of stocks, bonds, and
mutual funds fluctuate with changes in market conditions. Mutual fund shares,
when redeemed, may be worth more or less than their original cost.
