It’s common market wisdom that non-professional investors should “invest in what you know.” This makes intuitive sense, since we obviously have an informational edge in sectors that we work in. Furthermore, it’s scary and requires extra effort to investigate areas of the market in which we have no experience.

Imagine, for example, a lawyer who does a lot of work in the energy space. In the course of advising these businesses, he develops a reasonably strong understanding of the energy sector, including regions with the best drilling prospects, top management teams, local political conditions, geological and environmental complications, and other qualities of energy businesses. In addition, he probably has occasion to spend a great deal of time with top executives in the space who, being passionate about the sector, paint a compelling narrative about companies in the space. He has the “inside scoop.” In many cases, early investments in the sector work out, and regular socializing with executives in the sector further bolsters his confidence. Over time, it’s easy to imagine how a preponderance of his portfolio ends up concentrated in the energy sector.

Now imagine a highly successful entrepreneur in the construction and building sector. She knows a lot about new land development opportunities and investing in property in her area. As her businesses booms during a strong construction cycle, property prices skyrocket in her area, she reinvests her earnings in what she knows best – development and property, mostly in her home market. And for the most part, this works out beautifully in the intermediate term, since the real estate cycle is often a long cycle. Eventually, the vast majority of her investments – not to mention her business interests – are concentrated in the property sector.

In the context of long-term objectives it’s obvious that these highly successful people are under-diversified in their personal estates. They have concentrated the risk in their portfolio in one very narrow segment of the market, which is risky in its own right.  However, in these examples the portfolio risk is compounded by business/income risk, as their professional livelihoods are tied directly to the same risky sector as their portfolio.

As a result, when that sector undergoes a lengthy period of consolidation, their portfolios come under pressure at precisely the same time that their business is at risk. For a lawyer who specializes in this sector, this might mean a substantial drop in income, or a job transition. For a builder with debt, inventory, and/or projects half completed, this could mean restructuring, sale, or bankruptcy. Imagine having your portfolio crumble around you just as your job or business is in crisis. Worse, imagine this happening in the last few years before you had hoped to retire.

This is precisely the situation that is engineered through an approach to investing where you only invest in what you know best.

The great illusion is that, by virtue of being experts in these domains, they are able to exert some control over outcomes in their sector; or barring having control, they will be able to identify turns in the sector and exit near the peak. This may be the most dangerous fallacy of all. Over and over, we see the most successful and capable people fall into this trap.  There’s famous quote that bears mentioning here:

“It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

― Upton Sinclair, I, Candidate for Governor: And How I Got Licked

You see, it’s almost impossible to believe that a cycle is over when your livelihood depends on its continuation. Those who are closest to a sector are often the last people to acknowledge the ride is over. Everyone they know and respect remains optimistic; the insulation from the broader context is too thick. They’ve spent too much time in the trees; it’s impossible to see the forest burning down around them.

This outcome is the rule, not the exception.

Given the style and prominence of modern media outlets, it’s increasingly easy to reference successful entrepreneurs who attribute their remarkable success and centi-million or even billion dollar portfolios to the singular pursuit of the industry they know best.  The difficult reality of this situation is that even genuinely successful entrepreneurs have difficulty acknowledging the randomness of life.  For obvious reasons, nobody wants to talk about the multitude of unlucky failures who lost everything using the exact same methods others used to get rich.

The media loves the success story, and the successful can’t escape the illusion that they have complete control over their destiny.  As usual, the problem for most people lies in dis-aggregating luck versus skill; what worked for the few is highly unlikely to work for the rest.  If you happen to get lucky along the way, congratulations, but in the meantime you would be much better served focusing on the things you can control like portfolio diversification and risk management.

If you want to create enduring wealth alongside a successful business, avoid investing excess cash-flows in sectors close to your area of work. Instead, focus investments in strategies that are less sensitive to your industry’s economic cycle.  After all, the investor with liquid funds at the bottom of the market is in a powerful position to scoop highly productive assets at a discount. Sure, it requires patience, a long time horizon, and strategic vision. But this is precisely how successful entrepreneurs build sustainable dynasties.