Invest in businesses you can understand and ‘put your arms around’. It’s important to establish your circle of competence as an investor. If you don’t understand what the company does, or how they make their money, their strength, their weaknesses, and competitive position how can you forecast future cash flows in order to make a proper valuation of the company?
For example, take the time to understand what a company does by going to the mall or online and checking out their products and or services, looking at customer reviews, or reading and listening to quarterly and annual reports. Do the exact same exercise with their competitors. Furthermore, use your educational background, work experience, or even hobbies to help establish and accelerate the development of your circle of competence. Lastly, pay attention the local product and service trends in your neighborhood such as what your peers, family, and acquaintances are buying or talking about buying.
This concept is central to the investment methodology of famous money manager Peter Lynch, as well as Warren Buffet, amongst others. In taking this investment approach you will find that you will invest in less companies than you would otherwise, and this is a very good thing. Many stock market investors are over diversified and statistically most of the benefits of diversification are eliminated after investing in 8-10 companies within different industries.
Ultimately this might mean missing out on some great opportunities, but more importantly it will help you avoid catastrophic losses. If you can’t understand the businesses that you’re investing in you are not really investing, but rather speculating.