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.

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.

6 comments:

  1. Sample size can be one explanation for why your professional experience differs from the study. The other reason may be that your sample of clients is not a random sample, good be a common factor among your clients (education level, prior experience, location etc.).

    In hindsight we all wonder how we missed on Apple, Microsoft etc. However, one should not base their investing strategy on trends. If the growth is factored in by the markets, there is very little upside potential.

    Only investing in industries you know can lead to a high correlation, low diversification and increase your portfolio's risk. If I work in the pharmaceutical industry chances are that I know a lot about the industry and very little about any other industry. Only investing in pharmaceutical companies can be disasters.

    I don't think most of us have "special" knowledge of the industry we work in. Often what we know is public knowledge, analysts and institutional investors will have factored all that information into their valuation. If you do have "special" insight nonpublic information you wouldn't be able to trade on that anyways.

    Regardless of how much you think you know about a company or industry, rigorous research is a must.

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    1. Ray, thanks for your well-reasoned response, you raise several very good points.

      While I agree with your comment in general about trends and I would not chase every treand, there are ever once in a while, disruptive trends. I think we are often just too busy in our day to day life to observe them.

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  2. I have two other possible explanations for your observation that your clients do very well investing in professionally close stocks. The first is that if they hadn't done well, they wouldn't have become clients of yours. This suggests that there is a group of equally intellignet people who had bad luck and, consequently, don't ahve enough assets to justify using your services. The second possible explanation is that your very succesful clients are more memorable to you than the ones who lost money on professionally close stocks.

    I tend to agree with Ray that insiders rarely have special knowledge of the industry they work in that can help to get above-average returns.

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    1. Michael, thx for your comments, if you and Ray agree, my observations must be wrong :)

      But seriously, you raise a really intersting point, during a busy tax season I am probably only noticing the very good or maybe very bad returns, but too busy to notice that the professionally close results that are not great, but not significantly bad enough to remember. Considering my age and all the crap stuck in my brain, that may be the answer.

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  3. Thanks for the mention Mark and I enjoyed reading this.

    I fully agree where you are coming from. Most investors and most professionals over the long-term will not beat the indexes; so indexing makes total sense.

    Like you, I also 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. Our Great Recession of 2008-2009 was one such opportunity and there will be more, as you know.

    The struggle I had with Larry's comments, was the broad-brush statement (or maybe the title of the article) that investing in what you know is a bad strategy. I just cannot see what that is the case, regardless of what academia says.

    If I listened to Larry, my dividend income would not be increasing like it is, month after month after month.

    Cheers,
    Mark

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    1. Mark, as I am not the passive investing devotee that many bloggers are (although I am working at getting there and do agree, that for the vast majority of people, that is the way to invest)I know Larry's name only by reputation and how highly regarded he is by many.

      Thus, I appreciated the fact you politely challenged him. Whether you buy a diversified set of what you know (like you with dividend paying stocks)or follow Peter Lynch's mantra, there are times to challenge general convention, at least a few times over a lifetime.

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