My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Monday, April 2, 2012

Stock Pickers-The Industry Knowledge Trap

The Great Debate


Last month, Larry Swedroe, the Principal and Director of Research for Buckingham Asset Management, LLC, a well-known author, blogger and proponent of passive investing wrote an article titled “Buy what you know” is a bad strategy. In a nutshell, Larry said that a recent Norwegian study  has shown that individuals investing in "professionally close" stocks (meaning stocks of companies in fields related to their profession) did not outperform the benchmark indices. In addition, Larry references a book by Gary Belsky and Thomas Gilovich titled “Why Smart People Make Big Money Mistakes that rejects the "buy what you know" mantra of famed mutual fund manager Peter Lynch.

I found this article very ironic. You will understand why when you read my blog post below. Mark from the blog My Own Advisor then posted a blog titled I disagree with an expert buying what you know makes sense in which he challenged some of Larry’s assertions and stated he thinks buying what you know can be an excellent strategy, in particular, buying a diversified set of what you know over time.

After Mark’s blog stirred some debate, including some comments by Larry on Mark’s blog, The Canadian Couch Potato a well-respected Canadian author and blogger and passive investing proponent jumped into the fray, with a blog post titled When “Buy What You Know” Makes Sense stating that it struck him that Larry and Mark were arguing two very different points.

The three articles/posts make fascinating reading for both passive investors and stock pickers alike. So, why am I rehashing this debate weeks later? Well I had written a blog in October or November that I had not yet posted on how my clients following Peter Lynch’s advice, have used professional and industry knowledge to do very well in the market. I assumed professionally close investing would result in above average returns. My concern and reason for writing my blog post (see below) was that I felt that these clients appeared to be suffering from a false sense of stock market picking confidence outside of their professional or industry expertise, because of their better than average returns on their professionally close stock picks.

Since the study and book Larry referenced in his article seem to shoot down my personal experience, I debated whether to post this blog or not, but finally decided I will post my blog as initially written and append it with some comments based on the three above articles/blogs.

The following is the blog post I wrote before reading the aforementioned articles.

The Blog Post


In the first blog I ever wrote, Why Didn’t You Buy Apple for $25 I noted that famed money manager Peter Lynch in his book Beating the Street, suggested that average investors can beat Wall Street professionals by using information they encounter in their everyday lives. In the book, Lynch tells the story of how he invested in Hanes pantyhose because his wife told him how popular L'eggs pantyhose were amongst her girlfriends. In my blog, I discussed how anyone who observed the popularity of the iPod could have purchased Apple shares and made a substantial profit.

But, let’s say you are oblivious to trends. Don’t many of us have specialized industry knowledge we can take advantage of to purchase individual stocks on occasion? I would suggest that in many cases, the answer to this question is yes, and your special knowledge comes from where you work each and every day. Think about it, don’t you have a very strong knowledge of your industry, its trends, competitors and whether or not it is a growth industry?

As an accountant, I have seen many clients trade very successfully in their specific area of expertise, be it a technology or a manufacturing niche. However, although I have observed many people taking advantage of knowledge they have obtained in their employment capacity (obviously I am not talking about insider knowledge, but just knowledge of an industry and its trends) they often mistake a specific knowledge for stock market expertise. I have not observed any correlation between individuals making a profit on a company in an industry they know well and success in picking stocks outside their area of expertise, other than a reverse correlation.

I suggest that occasional stock pickers stick to their area of expertise and use index investing or professional management for the rest of their portfolio. If you spot a trend, you may consider allocating some of the more speculative part of your portfolio to chasing that trend.

Upon Reflection


If you are still reading at this point, I think you will now realize why I found Larry’s article ironic. I have always been a disciple of Peter Lynch’s philosophy that you should buy what you know or observe around you. In addition, contrary to the study, it has been my professional experience that those investing in “professionally close stocks” have actually beaten the benchmarks by a substantial margin; it is once they go outside their expertise, that the market extracts its revenge.

So the question arises as to why I have observed positive results for professionally close individuals as opposed to the Norwegian study. I would suggest two reasons: (1) Norwegian professionals are not as proficient as North American professionals and (2) My clients are very intelligent. 

For those that do not have a feel for my sense of humour, of course I am joking about #1 above. So why is my observation so different than the Norwegian study? I can only suggest that my client sample size is statistically insignificant and is thus skewed; and if I tracked a larger sample size over a longer period my results would reflect the poor professionally close results of the Norwegian study. In all honesty, I am still a little dubious of the study results; however, I am in no position to present a counter argument to a properly executed study.

However, I am not willing to totally dismiss Peter Lynch’s assertion that by using information we encounter in our everyday lives (this information can be information other than professionally close information), investors can beat Wall Street professionals.

To be clear, I do agree with the view that almost all investors and most professionals over the long-term will not beat the indexes; but I do believe that there will be say two to five stock market opportunities in our lives, either professionally close or just observational, that if we are paying attention will be there for the taking.

The most recent example being Apple. In retrospect, how could any of us not have seen the affect the iPod was going to have on society, as young person after young person purchased iPod’s, blared their music at us and yet many of us failed to realize this would cause Apple's stock price to explode, let alone allow Apple to change the music industry with iTunes. One could also argue the Internet was another significant opportunity if we paid attention. Yes, there was a dot.com bubble, but there were multiple  opportunities to make money before the crash if one had paid attention to the explosion of the Internet.

I ended up posting this blog for two reasons. The first reason was to highlight the excellent articles/blogs and related research studies posted by Larry Swedroe, My Own Advisor and The Canadian Couch Potato and the subsequent debate. The second reason was reflect how personal observation and a small sample size of my client's professionally close advantage results, could result in a misleading conclusion.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.