Is investing in what you know a dangerous thing?
I have learnt that it is best to invest in what you know (the business). But in an article I read that even Warren Buffett stands by it that it's dangerous to invest in what you know. Is that right?
It would be smart to invest in what you know, but I guess limiting yourself to investing in what you know can be dangerous in two ways according to me (and maybe that’s what buffet’s going for?): 1. You become narrow minded and miss out on potential opportunities that you can make a lot of money on i.e. instead of just investing in what you know, you can try to understand other businesses and make investments in them. 2. If you only invest in what you know, after a while, you might think that because of your understanding of the industry/sector, you might be able to come up with some short cut way to decide whether a business is a good investment or not, whereas in reality it takes time to go through the financials and understand each unique company
I haven’t heard buffet say this, but if he did, I guess this is what I would infer
Under the CAPM and the EMH, it is assumed that the average market participant's portfolio is well diversified. This means the average portfolio's risk is equal to the market risk. Therefore, investors are not concerned with idiosyncratic risk and the market doesn't compensate them for it.
If your strategy is to only invest in what you know, your portfolio is not going to be well diversified. You'd have to believe that markets are inefficient and that you can identify alpha opportunities that would generate greater returns than the market. The belief that markets are inefficient is needed for there to be alpha opportunities.
It's a dumb strategy if you think markets are efficient or if you're not adept enough to identify alpha opportunities. **It's dangerous to the extent that markets are efficient and that you are unable to identify alpha. **
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