When “Buy What You Know” Makes Sense

Last week, My Own Advisor wrote an interesting post about whether investors should buy companies they’re familiar with. He was responding to a recent article by Larry Swedroe, which argued that “Buy what you know” is a bad strategy. Swedroe himself even joined the spirited debate in the comments section.

As I read the post and the comments, it struck me that the two sides were arguing two very different points. In the interest of being a peacemaker, I’d like to frame this debate differently and find some common ground.

Why pick stocks?

Let’s start at the beginning by asking why investors pick individual stocks in the first place. Back in the days of Graham and Dodd, investors had little choice but to analyze and buy individual companies, since there was no way to “buy the market.” That hasn’t been true for a long time, of course. Today, buying the market is easier and less expensive than ever. With equal amounts of the Vanguard Total Stock Market ETF (VTI) and the Vanguard Total International Stock ETF (VXUS), for example, any investor can own 9,742 stocks in over 40 countries for an annual cost of 0.13%.

So if it’s cheap and easy to buy the whole market, why buy individual stocks? There are many specific answers, but I think all of them fall into one of two categories.

The first reason to pick individual stocks is that you believe you can outperform the market. This means either obtaining higher after-tax returns, or the same returns with lower volatility.

The second reason is less obvious, but it’s just as important. As Meir Statman has long argued, investing isn’t just about earning the highest possible returns. It also has expressive and emotional benefits. For example, you might choose socially responsible investing because it’s a way of expressing your values. Or you might simply find stock picking enjoyable, even exciting. You still want to earn healthy returns, of course, but lagging a benchmark may not be that important as long as you meet your financial goals.

When it comes to “buying what you know,” there is clearly an emotional benefit: familiar companies, especially those that pay reliable dividends, make investors feel safer. Indeed, judging by the comments on MOA’s blog and my own, this is far more important than beating the market. Some examples:

“I have slowly converted into a dividend investor, not necessarily because I think dividend stocks will outperform, but rather because I think quality dividend stocks offer a safer investment for me.”

“I will sleep easier at night holding a few big companies [rather] than all of the market… I will have a regular dividend stream of income, probably some decent capital appreciation, and a smoother ride.”

“My focus is not on earning higher returns than the market. The major attraction of a dividend strategy is the dividend itself.”

“I have more faith buying companies I know and understand, that have decent fundamentals and pay dividends, than a basket of stocks [where] I don’t have a clue what a third of the companies are.”

“For me, dividend investing is more predictable, with a return I am happy with.”

“To me it’s all about getting dividend checks in the mail, on a monthly basis.”

“Dividend-paying companies are not necessarily superior, rather they provide me with assurance about their long-term prospects.”

Finding common ground

So here’s the problem with this debate. When Swedroe writes that “buying what you know is a bad strategy,” he’s considering only the first factor. His argument is that if your goal is to earn market-beating returns, then buying familiar companies is a poor way to do that. And he’s correct—as I have argued in a previous post.

But the comments above make it clear that many dividend investors are not really interested in market-beating returns. They don’t particularly care which strategy is optimal when you run a thousand Monte Carlo simulations on a computer. They’re arguing that by “buying what they know” they will be more likely to stay invested during difficult times. And they’re right, too.

Their thought process goes something like this: “If I held index funds I’m afraid I would sell them if the markets tanked. But I take comfort from owning a basket of profitable, dividend-paying companies that I know will bounce back eventually. And for that reason, I’m more confident about staying the course.” It is hard to argue with that.

Yes, the data are clear that passive investing, when executed properly, is the optimal strategy for individual investors. But if you have no confidence in the strategy, you will never execute it properly. And if you abandon it at the wrong time, you’re guaranteed to fail. Confidently holding a portfolio of familiar stocks may be not be a market-beating strategy, but it is surely superior to being a jittery passive investor who will sell in a panic.

On that point, I think we can all agree.