Ask Stacy: Should I Invest in Stocks I Don’t Understand?

I recently got this email from a reader and think it offers terrific insight into how one should approach risky options like the stock market. Check it out and see if you can relate…

Hi Stacy,

I love your articles and tweets. They’ve been so helpful! thank you! My question, if you have time for me, is this:

I’ve slowly been learning how to place some of my savings in the market, but I’ve only invested in what I know – biotech and technology, two industries I’ve worked in and have studied financially. So far, so good. But when investment advisers say I should diversify, it get’s very daunting. I don’t know anything about say, Corning or General Mills or some other industrial sector. How can I feel comfortable allocating my hard-earned money someplace that is so unfamiliar? I even feel this way about my workplace-sponsored retirement plan. All of the allocations into unknown sources has me stressed! Is there any advice you can provide as to how you decided on your portfolio, what you would suggest to someone who has not been in the investing business, and maybe, just maybe, something that would make me feel more at ease about investing?

Thanks so much and please keep up the great work!
Erin

This is a super question, Erin, on many levels. First, let’s talk about what you’re doing right: investing in what you know.

Reading your question reminds me of an appointment I had years ago as a stockbroker. I met with a very successful surgeon who had never before invested outside of bank savings accounts. As his first foray into risk-based assets, he wanted to invest a sizable sum in sugar. Specifically, he wanted to short sugar futures – essentially placing a very risky $50,000 bet that the price of sugar would drop short-term. His logic? Because the rapidly growing popularity of artificial sweeteners would make the genuine article fall in price.

Coming from someone presumably very bright, this was a very dumb idea for at least two reasons. First, the existence of artificial sweeteners was hardly a secret, and therefore – duh – already discounted into the price of sugar contracts. Second (and to finally get to the point), this guy was constantly exposed to game-changing investment ideas in his chosen profession! He should have looking at potential investments in medicine and medical technology, not sugar.

This lesson is one that Erin has already learned, and good for her. Investing in things you know and understand is potentially more rewarding and definitely less stressful. That being said, however, financial advisers are right: It’s unwise to put all one’s eggs in the same basket, so Erin should diversify. The question is, how does one diversify into unfamiliar territory while still feeling in control?

When you look at my real-money online portfolio, you’ll see an abundance of companies about which I know basically nothing. How did I arrive at them? I used a three-step process…

1. I listened to my gut. Sometimes if you can just ignore the background noise, your gut will serve you well. Construction equipment maker Caterpillar, for example, was at $40/share when I first purchased it in 2008, then fell another 10 points to $30 when I bought it again in the spring of 2009. Caterpillar is the leader in their industry, and their stock was trading at prices not seen since 2003. While I don’t know a backhoe from a back scratcher, I knew that sooner or later heavy equipment would have to rebound. Since my investment horizon is more like 10 years than 10 minutes, it just felt right.
2. I minimized bankruptcy risk. While my portfolio is a mishmash of different companies, you’ll note that most of my companies have one thing in common: They’re big and leaders in their field. So while the economy and the markets may punish their stocks for months, or even years (as in the case of my bank stocks), they’re highly unlikely to go bankrupt. Which means making money is more a matter of when, not if. Look at GE, a stock I bought the first time at less than $8 a share. This is one of the largest industrial conglomerates in the world. If this stock is going to zero, the only thing worth investing in is guns and canned food.
3. I listened to what others were saying. This is the most important of my three steps. My brokerage firm (Vanguard) provides free stock research from Standard & Poor’s, Reuters, and other respected firms. Before I make a purchase, I read research reports written by people who make their living analyzing company financials. I don’t always follow their advice – virtually none of the companies I own had achieved S&P’s coveted 5-star rating – but they provide an objective view.

There’s one more piece of advice I’d offer that’s every bit as important as the advice above: If investing in individual stocks proves daunting, don’t do it. In fact, you can’t buy individual stocks in work retirement plans anyway. Solution? Buy the entire market in the form of an S&P 500 Index fund or ETF. These mutual funds mirror the returns of the largest 500 companies in America. They won’t go bankrupt and will ultimately reflect the value of the overall American economy: historically, a pretty safe 10-year bet.

Despite the fact that I have all these stocks in my online portfolio (and more in my retirement accounts) I have some money in Vanguard’s S&P fund. Check it out, Erin!

Got more money questions? Browse lots more Ask Stacy answers here.