Many people dip their toes into investing by buying shares of a company they love, but there are risks associated with diving into this type of strategy.
It turns out that brand loyalty doesn’t end after someone buys a stock; becoming a shareowner also affects spending decisions, according to a working paper published last month by the National Bureau of Economic Research. Among customers who receive stock rewards in their brokerage accounts, weekly spending at brands jumps by 40% and stays high for 3 to 6 months, the researchers from Texas A&M University and Columbia University concluded.
The spending component adds a layer of complexity to a pretty straight-forward mantra: "Invest in what you know." Famed investor Peter Lynch gets the credit for that one-liner, though the mutual fund manager has said those five words oversimplify his ideas about investing.
The advice lives on because of its simplicity, notes Sam Stovall, chief investment strategist of U.S. equity strategy at CFRA Research, who recalls reading it in Lynch’s 1988 book, One Up On Wall Street. “It’s understandable, and everyone can do it because everyone has some expertise in something.”
But is investing in what you know actually sound advice? “Conceptually, yes. In reality, not so much,” answers Terry Sandven, chief equity strategist at U.S. Bank Wealth Management. That’s because there’s an important distinction to be made between a good company and a good stock.
Separating a company from its stock
Even if you love a company — and its products address a need in a growing market — that information won't tell you much about its stock, Sandven says. Rather, you should research what's happening within the company, the competitive dynamics in the industry and macroeconomic factors that affect a stock’s price and valuation, he notes.
While familiarity with a company is a starting point, avoid making a one-dimensional investing decision, Stovall says. “Remember that you’re not alone in this investing world and other people like the stock and beat you to it, so it might be a pretty expensive purchase.”
Some investors adopt a herd mentality and pile into popular stocks to chase returns. That’s certainly been evident this year as stocks favored by the Reddit crowd, like GameStop or AMC Entertainment, have seen huge daily price swings. Meanwhile, other investors take a more subtle approach to investing in what they love. A new app, Grifin, recently got a big boost from TikTok investors because it automatically invests $1 in the publicly-traded companies where users are spending money. That’s a similar idea to Stash, which uses a round-up approach to invest in those companies where people are spending money, and Bumped, which offers fractional stock rewards when consumers shop.
The risks investing in hot brands
Investing in what you know has several potential downsides: You may get caught up in a feedback loop that reinforces questionable investment decisions, you may have blinders on to what’s happening elsewhere in the market, and you may be heavily concentrated in certain sectors that fall in and out of favor. Alone or combined, these factors put your portfolio’s performance at risk.
In 2020, some of the best performers in the S&P 500 were very investor-friendly, including tech and retail stocks, Stovall notes. This year? Beaten down sectors, like financial or energy companies, are doing well — but many people aren’t so familiar with these brands, he adds. Consumers are likely to have a strong affinity for brands in the technology, consumer discretionary, consumer staples, and communication services sectors, which make up just over half the weighting in the S&P 500. Investing in what you know means you could miss out on big gains in the broader market.
Focusing on well-known companies may also cause you to overlook lesser-known competitors in the same industry — and their better performance potential. “Each sector has companies that are very well known, as well as those that are emerging,” Sandven says. “Oftentimes, it’s the emerging companies that have products that are changing how we live, work and play.”
How to invest in what you love
The stock market can be fickle, so what’s the best way to maintain your loyalty without setting yourself up for regret? Embrace the stocks you don’t love (yet).
If you build a portfolio made up of stocks you know, fill in any holes by buying sector-focused exchange-traded funds (ETFs), like materials or real estate, Stovall advises. And don’t forget to diversify within sectors, adds Sandven, who recommends investing in a blend of well-known and relatively unknown names.
Current market dynamics also present a solid case for diversifying beyond what you know. As the U.S. economy recovers from the Covid-19 pandemic, there’s a debate among investors about which types of stocks will do better — those poised for secular growth (like technology companies) versus those that benefit from cyclical growth (like energy or industrials companies), Sandven says.
Finally, don’t let your loyalty to a company cloud your judgement about the stock, Stovall says. “Even if you like the company, if there’s no more upside potential for the stock, then just enjoy the company but don’t buy the stock.”