The Problem With "Investing In What You Know"
Chapter 32 of The Rational Investor
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“Invest in what you know.”
That is a piece of investing advice you’ve likely heard before.
While it is important to educate yourself before investing your money, investing in companies in the same sector where you earn your income is an unnecessary risk. If there is a high correlation between your income and your investments, you could find yourself in a painful (and avoidable) situation where you lose your income and the value of your investments crash at the same time.
In this chapter, I provide a few common examples of situations in which investors connect their paycheck to their portfolio and why rational investors seek to minimize the correlation between their human and financial capital.
Taking company stock
A very common form of compensation at start-up and tech companies is having some or all of your compensation come through company stock rather than cash.
Let’s say you’re a software engineer at a tech start-up making $250,000 per year, and your only financial assets are stock in the company you work for. You are passionate about your company’s mission, so you invest all of your money into the company. 100% of your human capital and financial capital are tied up in a single company. All your chips are on one number.
That looks pretty attractive during a bull market, and valuations for tech companies are rapidly expanding.
But as we discovered in the chapter of this book on factor investing and you realize that small, growth-oriented companies that are not yet profitable tend to fizzle out.
What happens if the start-up fails?
Your income and financial capital fall to zero.
How a rational investor working at a start-up would invest
The rational investor is not looking to get rich quick.
Instead, they want to “maximize their utility.” That often means taking just enough risk to reach the desired outcome while attempting to minimize the odds of a negative outcome.
Here’s how a rational investor working at a tech start-up would manage their finances to optimize risk-adjusted probable outcomes.
First and foremost, the rational investor seeks to minimize the correlation between their human and financial capital.
If they were offered the choice to be paid in cash or in company stock, they would opt for cash 100% of the time.
An ultra rational investor would likely take this a step further and might even take out a put option on the stock of the company they work for. This creates a kind of insurance policy that would further distance their human capital from their financial capital. In reality, nobody is actually that rational, and this is certainly not a recommendation to get involved in options trading.
The point is, that the rational investor always looks to minimize the correlation between human and financial capital whenever possible.
That means diversifying by geography and by asset class through a portfolio of low-cost index funds of stocks and bonds.
How correlated is your human and financial capital?
I use tech workers as an example because they often receive company stock as a core component of their compensation.
However, tech workers are not the only people who have their human and financial capital tangled up in a knot.
Think of the real estate agent who takes a portion of their commissions and invests in local rental properties. 100% of their income and their investments are placed on one bet; the local real estate market.
What happens if the local real state market goes into a major correction?
The agent will earn less commission
The value of their rental properties fall
The rent collected from those properties fall
All three of these things happening at the same time can be devastating for that real estate agent.
Or think of the small business owner who reinvests 100% of their profits into growing their business. They are “all in” with a single bet; their business.
What happens if their business fails?
They have no income and no financial capital to fall back on.
If you are an entrepreneur, I’m not advocating that you don’t bet on yourself or invest in growing your business. But once your business starts generating a profit, put your rational hat on and start taking a small portion of those profits and investing in assets that have a low correlation with your business.
When it comes to managing your career and your finances, here’s a rule of thumb: Invest your human capital in what you know and diversify your financial capital as much as possible.
This allows you to be a good entrepreneur and a rational investor.
Investing your human capital in what you know maximizes your earning potential.
That’s what it means to be a good entrepreneur.
Taking the money from your human capital and spreading it around in assets unrelated to your job or business helps you minimize the odds of being unable to pay the bills.
That’s what it means to be a rational investor.