Monday, February 23, 2009

Economics: Buy What You Know--If You're Normal

TORONTO, ONTARIO - The stock markets in North America today plunged about 3-4% today, placing them at the lowest levels in somewhere between five and fifteen years, depending on the index in question. While many are wringing their hands that the bottom has not yet come, with my retirement many decades away (if it ever comes), I am doing my best to ignore the state of the stock market. As I learned a long time ago, I have no particular expertise about picking stocks, and I never will.

A long-standing piece of advice for the stock market has been "buy what you know." In other words, if there was a product or service that you used that you thought was really exceptional, you should buy the stock of the company behind that product or service. If the product were really that good, then other people would clearly be buying it as well, the company would make a profit, and you'd get a nice return on your investment through solid dividends. A corollary to that rule, less consumer based, was that if there was a company you knew was a leader in an industry you knew well, a company that you'd like to work for, then you should invest in that company, since as an industry leader it would be likely to make money.

Not long after I entered the job market and thought I had some money to invest, I tried to follow that advice. The trouble was that I didn't really know anything about any mass consumer products of any kind. So, I was reduced to using the corollary. The industry that I thought I knew well was advanced biotechnology, drug delivery techniques, microfluidics, and so forth. There were two companies that I would have liked to work for that I expected to be industry leaders that I decided to invest in.

I happened to do this not all that long before the technology bubble burst in the early 2000's, but the general movement of the market doesn't explain all the money I lost on those two stocks. They lost about twice as much of their value as the average biotech stock of the era. Furthermore, both of them stayed much lower and did not recover nearly as much as their peers as the decade proceeded.

So what was wrong? It wasn't that I was substantially wrong about the companies. Both are still in existence today, though each has changed its focus somewhat over the years. Both are still companies that I would work for if given the opportunity today, and in fact I interviewed at one of them last October. Each has proven to be a market segment leader of some kind or another.

What went wrong was that "what I knew" was not relevant to the market at large. I'm intentionally not naming these companies for a variety of reasons, but the odds are you haven't heard of either company. The things they could do well could get a technologist trained in the field like me excited, maybe even a venture capitalist excited, but really making a killing by producing revenue like the markets care about--they weren't positioned to do that. They were positioned to make modest profits off useful niche products, but investors don't get excited about that. In fact, most investors don't consider this kind of company to have any value whatsoever--the risks of competition or technology failure are way too high for the modest returns that can be returned.

In an analogy with the consumer realm, it was as if I had known about a product that I wanted to use and was tremendously useful to me, but my mother and my friends would never want to buy it as they had no idea what I was doing with the product. The product might have a tremendous appeal to someone like me, but there weren't enough people like me to provide a large enough market for the product to make huge profits.

Basically, the bottom line was that I was too weird for "what I know" to make any difference in my ability to pick stocks well. This was obvious in the consumer realm, but I had to learn it the hard way in the industry realm, to understand that the corollary of the "buy what you know" rule didn't apply to me any more than the main adage did.

And the original about $2000 that I invested in those companies? Had I not sold the stock when it was worth about $1000, it would only be worth about $400 today.

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