Investing for Beginners: When "Buy What You Know" Is a Bad Idea
Yesterday, I showed how investing for beginners doesn't have to be as daunting as you might think. As someone who participates in our economy every day, there are lots of great companies you already know about. Many times, buying shares of these companies is a great investment decision.
Unfortunately, that won't always be the case. Sometimes, our favorite companies have poor business models; other times, management can be corrupt; and worse yet, there are some companies that make money in ways that are very difficult to comprehend.
This is why "buy what you know" is a great place to start, but requires continual learning. Below are a few examples of companies that are relatively well known but might not be the best investing choices for beginners.
Who doesn't love Pandora? I paid the $32 yearly fee for commercials to be taken out, and it's on in my house for hours every day. It's a company whose service I love, but beginners have to realize that there's more than meets the eye.
Every time Pandora plays a song, it has to pay a royalty fee for that song. That means that every song you listen to costs Pandora money. The only way to make up the difference is through advertising. As people listen to more and more music, advertising revenues need to keep pace.
So far, that doesn't seem to be the case. In 2012, Pandora's revenue from advertisers grew 56%. That's not bad at all. Unfortunately, the amount of money the company had to pay in royalty fees grew by 74%. That means that as Pandora got more popular, it was actually losing more money. That's not the greatest business model when we're focusing on investing for beginners.
Though the name might not immediately sound familiar, Diamond Foods is one of the leading providers of snacks in the United States. The company's assorted nut snacks are sold under the "Diamond" name, but it also offers Kettle Brand potato chips, Emerald trail mixes, and Pop Secret popcorn.
That's a relatively easy-to-understand business -- but with Diamond, there's a catch. Management had been fudging their accounting numbers for quite a while to meet outsize expectations and to help extract huge bonuses. When investors found out, the stock plunged 70%.
This is the kind of risk that's difficult for investing professionals, let alone beginners, to spot. It highlights the importance of continuing investing education as you grow more accustomed to your investments.
The vast majority of Americans use one of the country's big four banks: JPMorgan Chase, Bank of America , Citigroup , and Wells Fargo . It's easy enough to understand that a bank pays you interest to hold your money, lends that money out to others for a higher interest rate, and keeps the difference for itself.
But that's not the only way banks can make money. There are derivatives, credit default swaps, and collateralized debt obligations, to name a few. If you'd like to spend a few years really grasping these instruments, go for it. But even some of the former CEOs of these banks admit they don't know how it all works.
Investing for beginners can be made much more simple by focusing on companies that make money in ways that even a kindergartner could understand. Big banks simply don't fall under that category.
What it all means for beginning investors
There are literally thousands of companies that you can invest in. One way of narrowing down that list is by noting which companies you are already familiar with. This should give you a much more manageable universe of stocks to pick from.
From there, you've got to put in a little legwork yourself, to ensure you understand what you are investing in. Remember, at the beginning, the simpler the investment, the better. Don't get in over your head -- learning about investing can be a lifelong pursuit.
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The article Investing for Beginners: When "Buy What You Know" Is a Bad Idea originally appeared on Fool.com.Fool contributor Brian Stoffel has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.