However, we stopped short of suggesting you should begin with a list of your favourite brands & companies. While putting money into companies you idolise is undeniably wholesome, you may want to think twice before actually buying shares in the brewery of your favourite beer.
This also applies to buy shares in Marvel’s owner Disney Corp because you love their films, or snapping up shares in The Restaurant Group because Wagamamas is the eatery you visit most frequently.
Why could this investment approach come back to haunt you? In this article, we’ll explain why.
1. Investing at peak popularity
Think for a moment about the type of equity investments you’d love to make. Would it look something like investing in a company while it’s modestly sized and continuing to hold the shares as the business expands into the mainstream?
The main issue with choosing the brands you adore is that by definition this means that the brand is already in the mass market. Its period of explosive growth – where revenue could double every year for successive years – is probably behind it.
You may consider yourself to be a trendsetter or have niche interests, but either way, applying an ‘invest in companies you already know’ rule of thumb will bias your range of investments towards companies that have already succeeded commercially.
2. The popularity premium
When investors crowd into a company or group of companies, this has a detrimental effect on expected returns for new investors.
The first effect is that the share price will be high, making each share very expensive relative to the absolute value of predicted future earnings that may accrue to those shares.
If you’re excited about a brand and feel optimistic about its future, then you’re likely not the only one. This means that the company will be enjoying positive media coverage & investor sentiment will be high. The company could be overvalued.
To return to the simple question of what the best investments look like: from this angle, you’d want to invest in a company that has fallen out of favour and isn’t highly rated by investors. This can result in bargain prices.
You are virtually guaranteed to never find a bargain if you only engage with investments that are firmly in the public eye, are receiving positive PR on a weekly basis and give you warm fuzzy feelings.
Try looking off the beaten track for overlooked gems. Think infrastructure, chemical manufacturers and other ‘boring’ industrial stalwarts.
3. Sector imbalances
If we asked you to list your favourite brands and reduce this down to your top 20, what would that portfolio look like?
It’s not likely to be geographically diverse or cover most sectors. Consumer products groups and tech firms will probably feature prominently to the detriment of B2B or foreign brands.
Portfolio management experts try to curate a portfolio that spans across borders & sectors, to diversify the specific risks that will impact a narrow segment only.
This issue could leave your portfolio unusual vulnerable to a specific event (like the CPU shortage) than a broader basket of stocks.