But first, let’s look at something the defensive investor must always defend against: the belief that you can pick stocks without doing any home work.

In the 1980s and early 1990, one of the popular investing slogans was “buy what you know”. Peter Lynch-who from 1977 through 1990 piloted Fidelity Magellan to the best track record compiled by a mutual fund-was the most charismatic preacher of this gospel.

Lynch argued that amateur investors have an advantage that professional investors have forgotten how to use: the power of common knowledge”.

If you discover a great new restaurant, car, toothpaste, or jeans-or if you notice that the parking lot at a nearby business is always full or that people are still working at a company’s headquarters long after Jay Leno goes off the air-then you have a personal insight into a stock that professional analyst or portfolio manager might never pick up on.

As Lynch put it, “During a lifetime of buying cars or cameras, you develop a sense of what’s good and what’s bad, what sells and what does not.

Lynch’s rule – “You can outperform the experts if you use your edge by investing in companies or industries you already understand”-isn’t

Totally implausible, and thousands of investors have profited from it over the years. But Lynch’s rule can work only  if you follow its corollary as well: Finding the promising company is only the first step .The next step is doing the research”.

To credit, Lynch insists that no one should ever invest in a company, no matter how great its products or how crowded its parking lot, without studying its financial statements and estimating its business value.

Unfortunately, most stock buyers have ignored that part.

Barbara Streisand, the day trading diva, personified the way people abuse Lynch’s teachings.

In 1999 she burbled, “We go to Starbucks every day, so I buy Starbucks stocks”.

But the funny Girl forgot that no matter how much you love those tall skinny letters, you still have to analyze Starbucks’s financial statements and make sure the stock is not even more overpriced than the coffee.

Countless stock buyers made the same mistake by loading up on shares of because they loved the website or buying e-trade stock because it was their own online broker.

“Experts” gave the idea credence too. In an interview televised on CNN in late 1999,portfolio manager Kevin Landis of the first hand Funds was asked plaintively, “How do you do it? Why can’t I do it, Kevin?”, “Well, you can do it,” Landis chirped. “All you really need to do is focus on the things that you know, and stay close to an industry, and talk to people who work in it every day.”

The most painful perversion of Lynch’s rule occurred in corporate retirement plans. If you are supposed to “buy what you know”, then what could possibly be a better investment for you than your own company’s stock? After all, you work there; don’t you know more about the company than an outsider ever could?.

Sadly, the employees of Enron, Global Crossing, and WorldCom-many of whom put nearly all their retirement assets in their own company’s stock, only to be wiped out-learned that insiders often possess only the illusion of knowledge, not the real thing.

Psychologists led by Baruch Fischhoff of Cornegie Mellon University have documented a disturbing fact: becoming more familiar with a subject does not significantly reduce people’s tendency to exaggerate how much they actually know about it.

That’s why “investing in what you know” can be so dangerous; the more you know going in, the less likely you are to probe a stock for weaknesses.

This pernicious form of overconfidence is called “home bias”, or the habit of sticking to what is already familiar.

In short, familiarity breeds complacency. On the TV news, isn’t it always the neighbor or the best friend or the parent of the criminal who says in a shocked voice, “He was such a nice guy”? That’s because whenever we are too close to someone or something, we take our beliefs for granted, instead of questioning them as we do when we confront something more remote.

The more familiar a stock is, the more likely it is to turn a defensive investor into a lazy one who thinks there’s no need to do any homework. Don’t let that happen to you.


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