Rule #1: Invest in What You Know and Like
When I wrote 5 Things I Wish I Knew Before Buying My First Stock, I purposely left out information about how to buy individual stocks to keep things simple and actionable. Just knowing the 5 things in my eBook will make you a better investor and would have doubled or tripled my net worth had I known them earlier.
Now if you’re reading this post, then I’m sure you’re interested in buying individual stocks and want to know where to start. I’m going to break it down into one simple rule that anyone can follow:
INVEST IN WHAT YOU KNOW AND LIKE
Remember, this is just the first step to take before buying a stock. There are other steps, but this is the most important one for long-term investors.
“Invest in What You Know” – Peter Lynch
The concept of “invest in what you know” was popularized by legendary investor Peter Lynch. He mentions this in his New York Times bestseller – One Up On Wall Street. The concept is simple. In your daily life at work and at home, you purchase and use products. Perhaps you or someone in your family used Invisalign to straighten their teeth. These clear aligners are preferred by teenagers over metal braces. Invisalign is owned by Align Technology (ALGN), which grew from $30 in 2013 to over $300 in 2018, a Tenbagger in 5 years. Or maybe you have an Amazon Prime subscription, purchase items from them every week and love their fast shipping. Amazon stock (AMZN) could have been purchased for less than $150 in 2010. It reached over $2000 in 2018 – a 13-Bagger.
Stock ideas are everywhere and not very hard to find. The best ones are the ones whose products and services you already use. Multi-billion dollar mutual fund managers pay tons of money to research products of companies whose stock they intend to buy. You have a leg up on these funds since you may already own these products and in some cases used them on a daily basis at home or at work.
3 Levels of What You Know
I break down “what you know” into 3 levels. I’ve had the most success investing in companies in which I have level 1 and 2 knowledge. Here’s my breakdown.
Level 1 is the highest level of competence in a product or service. This is a product that you actually use on a regular basis. Some examples are an iPhone, produced by Apple Inc. (AAPL), or Kleenex by Kimberly-Clark Corporation (KMB), or Stitch Fix by Stitch Fix, Inc. (SFIX). If you use these products or services on a regular basis, you know about the value they provide, their pros and cons, their level of customer service, and a multitude of other attributes.
Level 2 knowledge is not quite as good as Level 1, but still very good. It’s where you don’t actually use that product or service, but you have specialized knowledge of its industry. For example, you may not drink Pepsi, but you may be a long-time Coca-Cola fan. You may even be a Coca-Cola shareholder and have made a lot of money on Coca-Cola stock. Because Pepsi’s products are so similar to Coca-Cola, you understand it well and can make an educated investment decision on Pepsi.
By investing in what you know, you’ve already unconsciously done some of the most important legwork required to learn about a company.
You may not have firsthand knowledge of a product or service or even its industry, but you may know of someone close to you that does. Or you may have a strong interest and go out and do your own research. Sure, you can also go out of your way to try a company’s products or learn all you can about a product that you don’t already know about. I call this Level 3 knowledge. It can be a good way to learn about companies, but its impact is not as immediately powerful as Level 1 and 2 knowledge that is more ingrained into your subconscious mind.
STICK TO LEVEL 1 AND LEVEL 2 STOCKS
Stick to Level 1 and Level 2 stocks and try to stay away from Level 3 stocks until you’ve gained Level 1 or 2 knowledge about them. Anything less than Level 3 knowledge and you’re just gambling. Level 3 stocks have gotten me into trouble on more than 1 occasion.
Invest in What You Like
I’d like to take Mr. Lynch’s quote one step further. Don’t just invest in what you know, but invest in what you like. You may know a product or company very well, but its values go against your own values. Sure, a lot of money can be made in these companies, but will you lose sleep at night knowing you own shares of a company that goes against your core values? Everyone’s values are different. One person may have no problem investing in tobacco companies, while someone else may lose sleep over it. If you’re the latter, then just stay away. There are dozens of industries and thousands of stocks to choose from. There is no magical stock that you must own in order to be a successful stock investor.
I Know It and Like It – Should I Invest in It?
Knowing and liking a company is just the first step in picking great stocks – potential Tenbaggers. But how do you decide if the stock is good to purchase at the current price? I’m going to save that for a future blog post series, so stay tuned.
For now, let me point you in the direction of some of my favorite books that have helped me in my decision making for buying stocks. Check out these 3 Books on How to Value Stocks you’re interested in learning more.
I’d love to hear what you think about this article? Leave a comment in the comment box.
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Donnie Nguyen is the founder and CEO of Wolves of Investing. He started investing in the stock market in the early 2000s. He follows the teachings of Peter Lynch, Warren Buffett, and other investing legends. When he's not investing or blogging, he loves spending time with his family traveling and experiencing the world.
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