Smart Stock Investing Rule #1: Buy What You Know

A major key to smart stock investing is to decide only to purchase stocks of companies whose business you are intimately familiar with.

Why It’s Important to Buy What You Know

Investing is intelligently exchanging money today for a potential profit sometime in the future.

Inherent in the definition of investing is risk. You may not make any money. You may even lose money. If anybody tells you otherwise, or promises you a high, ‘risk-free’ return, turn around and run the other way as fast as you possibly can.

Your success as an investor depends (to a large extent) on your ability to accurately assess a company’s risks. It’s impossible to understand what risks a company faces if you don’t understand their business. But if you do understand a company’s business, it makes smart stock investing pretty easy.

How To Know Whether You Understand A Business

Sometimes you just know. Like, I feel pretty confident that most people reading this understand Wal-Mart’s (ticker: WMT) business well enough to invest in it.

Here are some useful questions to ask yourself before thinking about investing in a company…

1. How do they make money? This is a biggie. If you don’t understand where a business gets its revenue from, you need to either..

  • research it until you understand it, or
  • find another company that you understand better. Bottom line.

If after researching a company, you still don’t get it, just move on, my friend. Just move on. It’s crucial for smart stock investing. There are plenty of fish in the sea.

(Wal-Mart is a retailer. It makes most of it’s money by selling goods directly to consumers through its physical and online stores.)

2. Who are it’s competitors? Another biggie. If you understand a business, answering this questions should be easy.

(Wal-Mart has a ton of competition. It’s main competition comes from other large-scale retailers that have wide product selection, such as Target and Costco.)

If you’re trying to understand a company that you’re interested in, and you want help finding it’s competitors, Yahoo! Finance has a cool tool for it.

  • Put the company’s ticker in the box at the top left corner that says “Get Quotes” to the left.
  • Once the quote comes up, click on “Competitors” on the left side.

This is what you’ll get..

Smart Stock Investing Begins With Understanding Your Company Intimately. Research Competiton.

This tool rocks. Not only does it show you who Wal-Mart’s competition is, but it also shows you some key metrics for each company. It lines them up neatly, side-by-side so you can easily compare. It’s an invaluable tool for smart stock investing.

3. What things could possibly happen that would be bad for this company? Smart stock investing involves anticipating risk. Can you think of any hypothetical scenarios that would totally suck for your company? If not, you probably don’t understand it well enough.

(There are some things that could potentially happen that would totally suck for Wal-Mart. They have some operational tactics that are considered unfair by certain groups. The main reason they’re able to engage in them is because of their size and bargaining power. This brings to mind two things–lawsuits and copycats. Another issue they’re facing is international expansion. If their brand isn’t accepted in foreign markets their returns will suffer. There are others, too, but this was just to give you an example.)

4. What things could possible happen that would be good for this company? This is the exact opposite of question #3 (in case you didn’t notice), and another key question for smart stock investing. What are some things that could hypothetically happen that would be awesome for this company?

(For Wal-Mart, if their brand was accepted with open arms in global markets, it would be sweet for them. But I don’t wanna give you all the answers. What else can you think of?)

5. Can you make any sort of educated guess about the probability of the results from questions #3 and #4? If you understand a company, it’s risks, and it’s opportunities, then you’re able to make a somewhat-educated guess about the likelihood of each scenario.

This is far from an exact science. But having a pretty solid estimate that you feel comfortable with is a key to smart stock investing. It’s also important to explain (preferably in writing) why you believe that.

(For Wal-Mart, I think the chances of good things happening are higher than the chances of the bad stuff. I don’t think lawsuits will have a big effect on their business because although their strategies may be unethical, I don’t believe they’re illegal. They have significant protection again’s copycats because what I believe to be their main advantage (logistics and supply-chain power) is difficult, costly, and time-consuming to duplicate. I feel 80% confident about those things. Also, I’m over 80% confident that they’ll be able to leverage these established competencies to foreign markets.)

Being able to answer these questions is a sign that you’re buying what you know. If you’re buying what you know, you’re well on your way to smart stock investing.

How To Find Businesses You Understand

There is definitely hundreds of public companies that you can easily understand.

Retail is usually a good place to start. Most people understand retail because you’re able to walk into the stores and see what they’re doing. Some public retail companies are…

  • Wal-Mart (WMT)
  • Costco (COST)
  • Target (TGT)
  • The Cheesecake Factory (CAKE)
  • Abercrombie and Fitch (ANF), and
  • BEBE (BEBE), just to name a few.

There are tons of other ones, too.

6. What’s your previous experience? What do you do for your job? What hobbies do you have? What else do you do for fun? (More Coming Soon)

Back to 4 Key Principles of Smart Stock Investing

Back to Home Page