#1: Invest in what you know.

Charlie Munger, Warren Buffett’s sarcastically brilliant sidekick at Berkshire Hathaway, once said, “The game of investing is one of making better predictions about the future than other people. How are you going to do that? One way is to limit your tries to areas of competence. If you try to predict the future of everything, you attempt too much.”
As human beings, there is no way we can possibly know everything about every company in every industry. It simply isn’t possible. Yet when it comes to making an investment decision, so many people forget this. They think they can properly value an ethanol plant just as well as a startup biotech company or a software business. Inevitably, they can’t. People make false assumptions (or no assumptions whatsoever) about a business they don’t know a thing about. And when the business
goes out of favor or the stock price falls, they are left wondering what happened.
For instance, think back to the 1990s for a second. How many people understood Enron’s business model? Did you really understand energy derivatives? Or how many could sit down and explain to me how Celera Genomics was able to sequence the human genome?

Probably not many.

When it comes to investing, you are much better off narrowing your focus to companies you can wrap your hands and mind around. If energy derivatives aren’t something you understand, how can you expect to properly assess whether Enron is a good company? You can’t.
With that said, take a look at your portfolio right now. Look at the businesses you own. Being 100% honest, how many of those businesses do you really understand? If you had to explain the business model to a 10-year-old, could you? If you couldn’t, you might be better off not owning that stock. As Warren Buffett said in his 1998 annual meeting, “I don’t want to play in a game where the other guy has an advantage...The fact that there’ll be a lot of money made by someone
in cocoa beans doesn’t bother me really. There’s going to be a lot of money made by someone in cocoa beans. But I don’t know anything about ’em. There are a whole lot of areas I don’t know anything about. So more power to ’em.”

In order to pass test No. 1, you have to understand the business. It must be within your area of competence or expertise. If it’s not, walk away.