Invest in what you know

Focusing on brands can skew the selection of stocks. Companies that establish leading brands are usually large and profitable. A key risk of buying brands as stocks is over-allocating to parts of the market that have driven recent performance. 

Examples of this in the U.S. include mega-cap technology stocks in the 2010s or the Nifty Fifty stocks in the 1970s. This can tempt investors to invest based on past performance, potentially missing changes in market leadership to other sectors, styles or regions. 

On the flip side, investors as consumers might know almost nothing about entire sectors or industries. Most consumers, for example, are not experts in industrial chemistry. In this case, investing in what you know could involve missing out on opportunities that may be unfamiliar but also bland and profitable. 

Another risk of familiarity is placing too much emphasis on narratives and personalities. The more investors know about a company, the more attention they pay to CEOs, social media and corporate marketing. Personalizing an investment can involve risks, such as paying too much for the prospects of future growth or holding losing investments too long. Valuation and risk management can get less attention when investors get too personal with their investments.

Familiarity with companies can also occur through work. For example, if an investor has a day job as a software engineer, they may be familiar with the challenges and opportunities faced by technology start-ups. This could cause them to invest aggressively in technology names. In the event of a downturn in the technology sector, this investor could not only lose their employment income but also see a dent in their investment portfolio. In this example, it could make sense for an investor to be quite deliberate in buying what they don't know — or at least investments that are not so closely related to how they earn their income.

The relationship between investment familiarity and investment success is quite mixed. Several large U.S. tech companies have been good brands and good investments, although sometimes with long spells in the investment wilderness.

Other U.S. or global technology firms, particularly those facing high levels of competition, have been good brands but mediocre investments. And some stocks, including consumer-related Canadian firms with dominant market positions, have been mediocre brands but good investments.

When it comes to considering an investment, familiarity with a brand can be a starting point but disciplined investors often apply a variety of perspectives, including:

• Macroeconomic: A company may have expanded over the last decade but is it positioned well for changes such as higher interest rates or reduced consumer spending? This will involve considering the company's major business segments and operating regions, likely from the company's annual report.

• Strategic: A company may have a popular brand and great technology but is management doing the right things to sustain a competitive advantage? This will ultimately be a matter of judgement but profitability relative to the company's industry may provide some clues. In our Stock Centre, enter the stock's ticker symbol and look at Fundamentals and Profitability.

• Valuation: A company may have room to grow but how much are you paying for a dollar of revenues, earnings or cash flow? In our Stock Centre, enter the stock's ticker symbol and review Fundamentals and Valuation.

• Technical: A company might seem to be a solid investment but is this a good time to buy, based on price trends and institutional volume? In our Stock Centre, enter the stock's ticker symbol and explore Technical Analysis.

Overall, being a consumer provides a useful but relatively limited perspective on an investment. Employing a disciplined process and considering an investment from a variety of perspectives can help reduce "familiarity bias" — the tendency to overrate what we know about a company as a consumer of its products or services.

A final thought, in the interest of balance, is not to dismiss investments simply because they are familiar. Many winning investments, including the technology giants of recent years, have gone on to achieve substantial gains long after they became household names. To become a winning stock, after all, means to be widely owned.