A Common Investor Mistake Created by Warren Buffett

May 08, 2018

Invest only in what you know, isn’t what billionaire and famous investor Warren Buffett is saying to beginner investors?

I’ll admit it upfront before you want to throw me tomatoes; Warren Buffett is a smarter and better investor than I am (and probably than I will ever become). Throughout decades, the Oracle of Omaha gave lots of nuggets of wisdom to any willing to follow his path. One of its most repeated advice and one I follow religiously is “Invest only in what you know”.

The problem with this piece of wisdom is that investors thought it all wrong. As human beings often do, we take a good advice, twist it to our reality and justify our behaviors and beliefs based on that twisted advice.

What happens when you invest in what you don’t know

If I had to take the opposite example (invest in what you don’t know), I’ll take the subprime mortgage crisis from 2008. A few years before the crash happened, the economy was rolling at a fast pace. Consumers were using their house as an ATM (remortgage) or like a year-end bonus (house flipping). Businesses were looking for higher yield for their short-term liquidity. On one side, we had banks starting to freak out on loans and the clients looking for higher yield. The big guys on Wall Street saw an opportunity and decided to “buy” banks book of loans and then repackaging it into a small black box to resell this product to yield seeking investors. It was a “safe” way to generate “additional yield” without compromising “liquidity”. The problem is that the investing product was so complex that nobody really understood how it works. When the consumers stopped paying its subprime mortgage, we all know all the story went…

The advice is all about understanding a company’s business model

Buffett’s advice is directly link to how he builds his own investment thesis. Before putting your hard-earned money into someone else’s hand, you should know what you are buying. Investing is not about giving money and getting shares in return. Investing is about participating in the growth of a company you believe in. How can you believe in a company when you don’t understand how it makes money? This sounds simple, but some investors forget that “they will find a way” or “this stock will soar” aren’t an investment thesis. At best, we can call this “hope” and we saw what happened when people hoped for GE not too long ago…

Here’s a trick. If you can’t explain what the business you invest in do to a 12-year-old, then you don’t understand how it makes money.

Fortunately, this part of the advice is usually well understood by most investors. Where the problem arises is when investors apply it to their portfolio. Many investors make a cognitive bias by linking what they know to their personal situation. They then justify their investment according to their personal vision of the world and their habits. This is where it all goes wrong.

Why you should not relate to your personal story

This situation happens to me all the time; one of my reader sends me an email about a company. I look at it and go through my 7 investing principles to see if this investment makes sense. I write down my investment thesis and publish my work on my site or at Seeking Alpha. When I write the company is a good investment, I usually don’t have much issues with other investors. But I never miss an opportunity to shed the light on a stock I dislike either. And here go tomatoes! Shareholders will tell me how wrong I am based on their belief and not their investment thesis. They would tell me that “they like this” and “don’t like that” and this is mainly why the company will thrive in the future. They started from what they know (their world, their vision, their tastes and habits) and extrapolated it to a multi-billion company situation.

This is how Starbucks (SBUX) will not grow because Joan think their coffee taste burnt.
This is how Tanger Outlets (SKT) will succeed because Henry likes trying his clothe before buying.
This is how Kraft Heinz (KHC) will thrive because Terry’s kids like Ketchup.

I obviously use fictional names to protect investors’ identity (and prevent myself from any lawsuit! Hahaha!). The point is that you should never relate to your personal situation. Unfortunately, you do not represent billions of people on this earth. We all have different lives and habits, this can’t be applying on a business model. You may very well hate to shop online and want absolutely to try on clothe before buying. That’s your right and that’s your taste. But the world is heading toward a different route. Face it, accept it, it’s not a belief, it’s a fact. You may dislike Starbucks Coffee, SBUX sells the most coffee in the world. Hey! I hate Tim Horton’s Coffee and it doesn’t prevent this business to be the largest coffee store in Canada!

I own Coca-Cola (KO) shares even though I never drink Coke. Coca-Cola is a money printing machine generating billions in dividend each year.
I own shares of Telus (T) and I’ve never been a client. Telus just happens to be the strongest wireless investment in Canada.
I even own shares of Lowe’s (LOW) when my favorite house renovation store is Home Depot (HD). HD was just too pricey when I made my purchase back then.

Understand how the business work, but apply facts for your investment thesis

In the end, there is nothing wrong with using Buffett’s advice about understanding how a business makes money. But this doesn’t mean you must like the business or how it makes money. What matters is that you use facts (and not YOUR facts) to establish your investment thesis. Don’t ask your friends about a company, do your own research, look out for growth vectors and consider where facts are pointing. After all, with a little bit of research, you can do everything! I even fixed my sewer pipe myself in the middle of Mexico!