Never Invest In Something You Don’t Understand

Billionaire Wall Street icon and Berkshire Hathaway (ticker: BRK.A, BRK.B) CEO Warren Buffett has admitted he missed a huge opportunity by not investing in, Inc. (AMZN) and Alphabet Inc (GOOG, GOOGL) subsidiary Google. In fact, during the technology explosion that has created countless millionaires and billionaires over the past 20 years, Buffett’s technology investments have been few and far between.

In Buffett’s defense, he has a good excuse for not investing in technology stocks. When approached by Google prior to its 2004 initial public offering, Buffett passed on an investment opportunity because he didn’t understand how Google would produce a profitable and durable competitive advantage over its peers.

“I had plenty of ways to ask questions or anything of the sort and educate myself, but I blew it,” Buffett said of Google.

But his missed opportunity with Google and Amazon is just one example of a much broader Buffett.

“Never invest in a business you cannot understand,” he once said.

Buffett doesn’t seem to have an affinity for the technology business, so he simply avoids it all together. Sure, he misses out on a few big winners like Google and Amazon, but he also doesn’t expose himself or Berkshire investors to the risks associated with investing in something he doesn’t fully understand or appreciate.

It may seem like common sense for people not to invest in things they don’t understand. Unfortunately, it happens a lot.

The thousands of investors who bought mortgage-backed securities during the recent housing bubble are an excellent example of this type of behavior. Investors had no idea many of those securities contained such low-quality loans.

Technology and biotechnology companies often have products or services that require a high level of expertise to understand. For example, unless an investor specializes in electrical engineering, software development or another related field, it may be extremely difficult to understand a cloud services company’s new line of product offerings.

Buffett famously said he has three boxes for investment ideas: in, out and too hard. If a company’s business or product is too difficult to understand, it’s better to just file it in the “too hard” category and move on to another opportunity.

Cloud computing may be a huge growth opportunity in years ahead, but without an understanding of the field, niche cloud services stocks may simply be “too hard” for the average investor.

Cornerstone Wealth chief investment officer Chris Zaccarelli says investors should always remember that a share of stock represents partial ownership of a business.

“Just as you would never purchase a private business from someone else without at least looking at its sales, profits, debt and trends of all three of those things at a bare minimum, you need to do the same thing before purchasing stock in a company,” Zaccarelli says. “If you are doing anything else, you are just hoping what you bought will go higher – and hope is never a good strategy.”

Sometimes investors may perfectly understand a company’s product without understanding the company or its stock. TJB Research analyst Tom Brakke says this type of ignorance is dangerous.

“We are naturally drawn to companies that make products that we like or that provide services we think are valuable. But there’s a big difference between interesting products or companies and good stocks,” Brakke says. “If the business model of a company isn’t a sound one, it may never be financially successful.”

Twitter (TWTR) is an excellent example of a hugely successful company with a stock that has lagged in the market. Twitter’s social media platform may be more popular than ever, but its stock is down more than 40 percent in the past three years as the company struggles to monetize its huge user base.

Investors without business or stock market expertise shouldn’t be scared away from the stock market all together. Jamie Cox, managing partner for Harris Financial Group, says there is no problem with investors buying stocks they don’t fully understand as long as they make sure not to put all their eggs in one basket.

“Investors invest in things they don’t understand all the time – choosing to take a chance on a concept, theory or even a dream for future returns,” Cox says. “Where investors make broad mistakes is through over-allocation to these types of companies.”

Buffett himself once said that “diversification is a protection against ignorance.”

By investing in low-cost index funds, such as the Vanguard 500 Index Fund (VOO) or the Schwab U.S. Broad Market ETF (SCHB), investors who aren’t experts in software development, artificial intelligence, derivatives trading or biochemistry can safely invest…

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