Yahoo Finance 3 Ways to Broaden Your Investing Horizons
Legendary investor and former Magellan Fund manager Peter Lynch famously popularized this investment mantra more than two decades ago: Invest in what you know. "Investors are prone to seek out what's familiar because it's comforting," says Bob Landry, chief investment strategy at United Capital in Irving, Texas. "They believe they have an edge over other investors when they think they know a business or industry well."
The question is whether the advice of yesteryear remains relevant today. The answer depends on how you interpret Lynch's advice.
Dana D'Auria, a managing director at Glastonbury, Connecticut-based Symmetry Partners, says the typical interpretation is identifying "good" stocks among companies that an investor has had positive experiences with as a consumer. This is a simplistic approach that leads investors to seek out the familiar, but "people mostly don't follow the advice the way Lynch intended -- by doing a lot of research on a particular equity so that you actually do know it."
Choosing familiar companies has drawbacks, however. Investing in sectors or areas that you're knowledgeable about could make you overconfident and potentially lead to an unbalanced portfolio, says David Brooks, founder and president of Retire Smart in Omaha, Nebraska. If that happens and then the sector goes through a rough patch, your portfolio could be exposed to more volatility than necessary. "Volatility in a sector could then influence an investor to make an emotional decision and possibly sell at the wrong time."
[See: The Ultimate Guide to Dividend Stocks.]
You also run the risk of overlooking equally good or better investments, says Daniel Prince, head of iShares U.S. wealth advisory product consulting at BlackRock in San Francisco. "Too often investors miss the forest for the trees -- they learn as much as possible about a comparatively small sliver of the market and invest heavily there because they feel well-informed." In the meantime, those same investors may be missing opportunities elsewhere.
Emerging markets are a perfect example. "Over the past year, we've seen massive returns in emerging markets, but I'd guarantee that some investors missed out on those returns because they were biased toward investments that were closer to home," Prince says. When investors stick to U.S. markets only, a significant amount of upside potential -- namely that from the rest of the world's economic activity -- may get left on the table.
Fortunately, breaking out of the "buy what you know" mold doesn't require a complete overhaul of your investment strategy. Here's how you can easily broaden your outlook and avoid pigeonholing your portfolio.
Follow the law of opposites. Philosophically speaking, the law of opposites says that unity can be found in opposing forces. When applied to investing, the law means choosing investments that don't necessarily move in sync. "Diversification works best when we use non-correlated assets," says Rick Wedell, chief investment officer at RFG Advisory in Birmingham, Alabama. "You get the most benefit of diversification when you have a fairly large number of investments that perform independently."
Tech stocks, for instance, may perform well while industrial stocks lag. International stocks may climb while domestic equities take a step back. "That mix of performance generates a less-volatile return profile while not diversifying away the returns that you should receive from being invested in the market," Wedell says.
To determine which non-correlating investments you may want to introduce, look at your portfolio's total composition and consider which asset classes or sectors might behave differently from those you already own.
Market conditions can also influence your decision. "With valuations as high as they are today, I don't necessarily believe it's prudent to be diving into anything speculative," says Andrew Wood, retirement planning advisor at Daniel A. White & Associates in Middleton, Delaware.
[See: 7 ETFs to Ride the Gold Rally.]
In a bull market where stocks are experiencing short bursts of volatility and concerns about rising inflation abound, real estate can be an effective hedge. Gold, Treasury inflation-protected securities and hedge funds are other alternatives that can offer low correlation to the market and to one another.
Keep it simple. Investing in something other than the companies you know can be intimidating. Brooks suggests starting small as you venture into new investment territory. "No more than five percent of your portfolio should be put at risk when testing new investments."
That smaller scale allows you to cast a wider net without stepping further out on the risk curve than you'd like to be. Landry says the percentage or dollar amount of your portfolio that you choose to invest should be an amount you could stand to lose if your investment doesn't pay off. He says investors shouldn't underestimate the difficulty of picking investment winners, particularly in unfamiliar waters.
Prince recommends increasing exposure to new markets gradually and starting with a broad universe. One of the best ways to do this is by investing in exchange-traded funds, he says. ETFs provide simple, low-cost access to new investments while minimizing the risk associated with holding highly correlated assets.
Wedell also advocates using mutual funds or ETFs to introduce new investments and cautions against diving into high-risk alternatives blindly. "In general, all but the most sophisticated investors should be wary when treading into options, futures or funds that use leverage to create double returns." He says commodities may also fall into that bucket. These alternatives may be viable asset classes for some investors, but they carry a substantial risk if you make the wrong decision.
Get the right advice. If you've started introducing new investments to your portfolio, have a financial advisor look over your shoulder. "Ask them to perform a portfolio analysis to look for investment overlap, and if it's there, consider re-allocating to areas you don't have exposure to," Brooks says.
Talking to other investors is also helpful, but reinforce those conversations with advice from a professional advisor, says Adam Nugent, owner and advisor at Foresight Wealth Management in Draper, Utah. "You worked hard to earn your investable dollars, so you have to be willing to seek maximum opportunity for those dollars."
[See: 10 of the Best Cheap Stocks to Buy Under $10.]
Nugent says steer clear of red flags such as an advisor presenting an opportunity that isn't explained clearly. A good benchmark for gauging the potential of new investments is to ask advisors if they've invested in it themselves, he says. "If they say yes and can verify it, you're being presented with an authentic opportunity."
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