Inside The 'Circle Of Competence'

If it were up to Peter Lynch, "Buy what you know" would be the only advice you'd need. And Fidelity's white-haired poster boy and former money manager did have a good idea. But somewhere along the way, buy what you know took on unintended meanings. Investors who followed it unthinkingly are now feeling acute pain.

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What went wrong? Novice investors certain they had to be in stocks but unclear on where to start redefined "what you know." Suddenly it embraced everything from stocks everyone was talking about at dinner parties to shares in companies they were familiar with but failed to grasp as investments--an important distinction.

Lynch had it right. Investors who pick stocks for themselves must stay within a carefully drawn "circle of competence," deliberately setting down what they know and what they don't. Drawing that circle should be an investor's first task. Doing so shrinks the vast universe of publicly traded companies--more than 7,000, not counting penny stocks--to a manageable number.

Turning away from promising-sounding opportunities can be tough, especially when you hear a tip that makes you feel you know something about a company that others don't. This is especially tempting in the technology sector. But the more bleeding-edge a company's technology, the more likely it will be trumped by a sharper competitor or an unforeseen event. The more unproven its business--and the more unknown the demand for its products--the more vulnerable it is to economic downturns. Every step investors take outside their "circles" makes foreseeing trouble more difficult.

And investors may ignore potential blind spots because they think themselves expert: consider application service providers (ASPs), which rent ready-to-use software packages to businesses (the traditional alternative is buying software directly and installing it yourself). It was a new business model, and that was part of the ASP attraction. Corio and other ASPs quickly acquired market valuations into the hundreds of millions based on the cost-savings advantage ASPs supposedly offered clients. The problem was that the ASP customer base had too many dot-com firms in it. When these companies burned through their cash in the last half of last year, they stopped paying their bills. Demand from larger, more established firms wasn't there yet.

This phenomenon isn't purely the province of born-yesterday companies, however, and AT&T is perhaps one of the best examples of this in recent years. Long considered the proverbial "safe stock" because of its powerful position as the nation's leading provider of telephone services, last year it abruptly abandoned long-held plans to sell an all-in-one package of telecommunications services--from phone to Internet access to cable TV--moving instead to divide the company into a handful of separate companies.