Warren Buffett's investing advice can harm lay investors

Interview based on research by Bart de Langhe

It's not news that the welfare state is under pressure. Governments around the world are reconsidering their investments in pensions, healthcare and unemployment benefits. Individual consumers are being called on to make complex financial decisions that have major implications for their welfare. A growing number of consumers invest in the stock market to secure their purchasing power, but many make rampant mistakes.

In this financial adventure, consumers often follow Warren Buffett's advice to "stay within your circle of competence." But research by Esade Associate Professor Bart de Langhe, together with Andrew Long and Philip Fernbach at the University of Colorado-Boulder, proves why the business magnate's advice doesn't always work for consumers and, in fact, can be a double-edged sword.

Do Better: Should consumers stop listening to Warren Buffett?

Bart de Langhe: Most investors know Warren Buffett's advice to "invest in what you know." Before you invest in a company, you need to do your research. If you don't understand a company's fundamentals, how would you know if its stock provides a good investment opportunity or not? If the company is undervalued it makes sense to invest, but if it's overvalued it doesn't.

The advice makes sense...

It does. But it requires hard work and deep knowledge. The problem is that many people confuse a vague sense of understanding of what companies do with the fundamental research that Buffett is advocating.

We found that people believe it's less risky to invest in companies they feel they understand

What does your research reveal?

We found that people believe it's less risky to invest in companies they feel they understand. For instance, most people feel they know what Starbucks does. They sell coffee and croissants, and they do this all over the world on every street corner. But that sense of understanding of course does not give an indication of the true complexity of the business or investment risk. Nevertheless, we find that people rely on this sense of understanding to evaluate risk.

Are consumers completely wrong?

People's sense of understanding is completely unrelated to actual risk. If you want to invest in the stock market but are afraid of risk, you might put your money in companies that you feel you understand, believing that this will give you little exposure to risk. In fact, the companies you feel are easy to understand have exactly the same returns and the same volatility as the companies you feel are difficult to understand.

How did you demonstrate this correlation?

We conducted many studies in which we presented people with descriptions of companies in the S&P 500. These descriptions provide information about what the companies do, the different divisions, who the CEO is, etc. In one study, we asked people to rate how well they understood what the companies do and how risky they thought it was to invest in these firms. People rated companies they understood as less risky.

But when we tracked the rate of return and the volatility of these companies in the stock market in the following year, we discovered that there was no relationship whatsoever between people's ratings of understanding and what actually happened in the future, which in a way is not that surprising.

The companies you feel are easy to understand have exactly the same returns as the ones you feel are difficult to understand

We also found that these beliefs ended up influencing people's investment decisions. Risk-averse investors were more likely to invest in companies they understand, and risk-seeking investors were more likely to invest in companies they do not understand. This was the case for novice investors and for more experienced investors who trade weekly and hold over $100,000 in assets in their portfolios.

Who can benefit from these findings?

In the first place, people like you and me. Investing some of your money in the stock market is a great idea in the long term. More people should do it. Our aim is to protect people from making mistakes. Financial services firms are making it easier every day for lay investors to take part in the stock market. That's a fantastic opportunity in principle, but there is a danger of making dramatic mistakes.

There are now apps to download on your phone that allow you to invest in companies on the go. Imagine that you're walking around the city, see a store packed with people, and pull out your phone to do some basic research. You can immediately invest in the company. Marketing materials for these investment apps often echo the "invest in what you know" advice. We hope our research will shield people from the dangers of using these apps and help them form better-calibrated intuitions about risk.

But financial advisors can also benefit from our findings. Understanding the psychological drivers of risk perception is key when interacting with clients. Of course, we hope our insights will be used for the benefit of consumers, not to take advantage of them.

What is your advice for consumers?

Most people's true circle of competence is irrelevant because its radius is zero. So, just put your money in a highly diversified portfolio of stocks and minimise transaction costs and fees. Invest in index funds, for instance. The challenge is to stick with this strategy. It's puzzling for economists that so many consumers invest so much in individual stocks but so little in index funds.

Our research helps explain this puzzle. People might prefer investing in the very few companies they understand because they feel they know what they are doing, and they perceive little risk. But the opposite is true, diversification reduces risk. Yet because investing in many companies is harder to understand, people may have the false belief that doing that is riskier.

This interview is based on research published in the Journal of Marketing Research.