Peter Lynch is one of the most famous fund managers in the world. He managed the esteemed Magellan Fund and achieved a 29.2% average yearly return.
He shared his investing philosophy in his book Beating the Street. In this book, Lynch listed 25 golden rules for investing.
Taken that the book was released almost three decades ago, it’s worthwhile to check in on these rules and see whether they still apply today.
So, Investing Aid will investigate!’
1. Investing is fun, exciting, and dangerous if you don’t do any work.
Can’t really argue with this one. Investing can be intriguing and at times, more than exciting.
However, it may be the most expensive hobby you will ever have if you don’t do your homework.
If you’re an investor who picks his stocks, you must be ready to do the work of analyzing the companies you buy. Without knowledge about the companies, you’re basically just guessing.
One of the core lessons that Lynch has taught us is that you have to know what you invest in.
2. Your investor’s edge is not something you get from Wall Street experts. It’s something you already have. You can outperform the experts if you use your edge by investing in companies or industries you already understand.
Most of us have an industry we understand better than others, even though we rarely recognize it.
Usually, the knowledge comes from your job – if you work for a company, you tend to understand the field and the company itself.
For example, When I was young and worked for an IT company for a time, I saw they began to implement an aggressive marketing strategy with a new and superior product.
Due to my lack of experience, I didn’t recognize the vast growth potential. Sure enough, the company went up fivefold in a couple of years.
Sometimes it pays to be interested in the company you work for.
Another matter is that can you beat the experts (fund managers etc.) with your information.
As I mentioned in my text, where to get investing information, nowadays it’s quite hard to gain an edge with information.
The best kind of information is the kind you know before others. In my example, there was a benefit to be had, because the markets didn’t yet recognize the potential of the new product.
Of course, it didn’t take long for the analysts and fund managers to recognize the potential.
It’s worth remembering that at the time of writing Beating the Street (1993), information was still scarce, and you could benefit from having more knowledge than others.
3. Over the past 3 decades, the stock market has come to be dominated by a herd of professional investors. Contrary to popular belief, this makes it easier for the amateur investor. You beat the market by ignoring the herd.
This one’s a bit difficult to analyze. There are more professional investors and AI making stock trades than ever before. The stock market is dominated by algorithms and professionals.
About 70% of trading in the U.S. and other developed stock markets is done by algorithms.
I think it’s still an open question whether algorithms will make things more or less difficult for individual investors in the long run.
Overall, if you’re a long-term investor, you should focus on the companies, not on market sentiment and other herd movements.
Short-term investors, on the other hand, might want to stay in touch with stock market sentiment and ride the momentum.
4. Behind every stock is a company. Find out what it’s doing.
As an advocate of rational and fundamental investing, I’d say this is the cornerstone of all investing.
If you invest in a company that you don’t understand at all, you’re merely speculating.
It’s next to impossible to make any kind of rational decision about a company if you have no idea what the company actually does.
We learned this quite well during the Internet bubble in the late 1990s when every company that had a .com in its name went up like a rocket.
You shouldn’t buy something you don’t understand. Sometimes people spend more time deciding what kind of a table to buy than what they invest in.
When you buy a stock, you buy the company. At the end of the day, they are the same thing. If you would become an entrepreneur, you wouldn’t buy or start just any company, you would get into something you understand. It should be the same with stocks.
5. There is no correlation between the success of a company’s operations and the success of its stock over a few years. In the long term, there is a 100% correlation between the success of the company and the success of the stock. It pays to be patient and to own successful companies.
The longer the time frame, the more companies’ fundamentals matter.
Successful companies aren’t necessarily appreciated in the short term, but people will recognize the winners sooner or later.
It’s worth remembering, that it might take a long time for the marker to recognize a successful company.
The problem is that the holding periods of stocks are, on average, a lot shorter than one might think.
According to Reuters’ investigation, the average holding period for stocks in the 2020s has been less than 6 months.
It will take a lot longer for the stock to follow its fundamentals. Patience is still a virtue, especially in investing.
6. You have to know what you own, and why you own it. Never invest in a company without understanding its finances.
One of the essential skills investors should have is the ability to understand companies’ financial reports.
This one is especially important during a strong bull market when stock prices are rising above fundamentally acceptable levels.
Sometimes markets raise stock prices through the roof without any specific reason. The balance sheet might be full of garbage and the business model completely unsustainable, and still, the stock price is at astronomical levels.
The same thing can happen during a bear market, when everything goes down in price, even the great companies. This is when it really pays to understand the finances because it enables you to make great purchases.
It’s when the times are bad that companies are truly tested. When everything is going from bad to worse, you start to appreciate a strong balance sheet.
Strong companies can handle a few bad years, whereas overly indebted companies have a real risk of going out of business when the debts need to be paid, but there is nothing to pay them with.
7. Long shots almost always miss the mark.
By long shots, Lynch is referring to companies that carry a significant amount of risk but promise a high reward-
These can be high-tech growth companies or companies that are going through a difficult time.
The problem with long-shot companies is that there are about one or two things that can go right and quite a lot of things that can go wrong.
Needless to say, that it requires a high level of skill to pick the companies that make it in the end.
Sometimes I hear people saying have a “hunch” or a “good feeling about this one”. Hunches and feelings aren’t the cornerstones of thorough fundamental analysis, and they rarely lead to good results
If you do decide to make a long-shot investment, make sure you invest only the amount you are comfortable losing, because with these kinds of companies you likely are.
8. Owning stock is like having children – don’t get involved with more than you can handle. The part-time investor probably has time to follow 8– 12 companies. There don’t have to be more than five companies in the portfolio at any one time.
This one doesn’t necessarily apply to everyone, because you have to be able to pick the five winning stocks, which requires quite a lot of skill.
In long term, a focused portfolio has the highest potential of achieving great returns.
Of course, to get those exceptional returns with five companies, the five companies have to also be exceptional.
A focused portfolio of five companies requires a high risk tolerance, which is why probably isn’t suitable for most investors.
The better you know the companies the less risk you take. If you aim to have a portfolio of five stocks, you should know the companies extremely well.
9. If you can’t find any companies that you think are attractive, put your money in the bank until you discover some.
There’s no point in spending money if you don’t have anything worthwhile to buy. Saving cash for future purchases is a lot harder than one would first think.
The more you accumulate cash, the more buying opportunities there seem to be. You start to develop a fear of missing out on returns.
In general, if everything in the market seems to be expensive, it’s probably not the best time to make purchases.
If you find yourself justifying your expensive buys with, for example, exceptionally promising growth potential, you might be heading for a fall.
Opportunities arise all the time, there is no need to rush. It’s better to wait a while to make a great purchase than hurry and make an adequate one.
10. Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets. Always look at the balance sheet to see if a company is solvent.
This one’s pretty much the same as rule number 6.
A strong balance sheet is especially important for growing companies that need to allocate a large portion of their capital to research & development.
A company should have enough assets to endure years of hardships because eventually there will be hard times.
If a company has too many liabilities, it will eventually be in trouble. A strong balance sheet is the foundation of a successful company. Companies with poor balance sheets are the ones that are most fragile during a stock market decline.
11. Avoid hot stocks in hot companies. Great companies in cold, non-growth industries are consistent big winners.
These are the stocks that are usually overhyped. Investors have built castles in the air and often the fundamentals are forgotten.
Hot stocks are usually priced higher than out-of-fashion stocks, which diminished the expected return rate.
Now, it’s worth mentioning that if you’re a short-term investor and want to ride the hot stock rocket for a while, you might get satisfying returns.
The problem is that you’d have to get in early and know when to jump out. Unfortunately, investors often buy the hot stock when it has reached its peak, and all that is left is the falling stock price.
It’s wise to remember that with hot stocks few winners make spectacular returns, and a large crowd of others gets burned.
12. With small companies, you’re better off to wait until they turn a profit before you invest.
Absolutely correct, and most of the time the wisest thing to do.
Sure, you make the biggest profits when you invest early on, but to make long-term returns, the company has to eventually be profitable.
It’s important to make sure that the company is even capable of making a profit. In short term, you can live on expectations, but you have to get out before things get bad. Unfortunately, you never know when the time is right.
The profitable business model is, in the end, the only thing that supports the stock price in the long run.
13. If you’re thinking about investing in a troubled industry, buy the companies with staying power. Also, wait for the industry to show signs of revival. Buggy whips and radio tubes were troubled industries that never came back.
This rule boils down to the last sentence. It doesn’t really matter how great the company is if the whole industry has become obsolete.
If the industry is steady and evolves through time, it’s safe to assume that strong companies will be doing well eventually.
It’s wise to find out how the company has been doing in past downturns. If the company has always bounced back without problems, it’s quite safe to assume it will do so again.
Companies with staying power are the ones who innovate new products to stay in the game. They have strong balance sheets and a competent workforce that enable research & development.
Just remember that before you decide whether the company is truly a great one, check how the industry is doing overall.
14. If you invest $1,000 in a stock, all you can lose is $1,000, but you stand to gain $10,000 or even $50,000 over time if you’re patient. The average person can concentrate on a few good companies, while the fund manager is forced to diversify. By owning too many stocks, you lose this advantage of concentration. You need to find a few good stocks to make a lifetime of investing worthwhile.
As we know, Lynch is famous for his long holding periods. The logic is sound – you can’t make exceptional returns if you sell a stock every time its price has doubled.
However, it’s quite hard to hold on to stock after it has tripled or quadrupled in value. One of the greatest challenges in long-term investing is to learn how to handle profits, not losses.
Lynch also makes an excellent point about concentration. The biggest investment fortunes have been made with focused portfolios.
Of course, it’s worth remembering that Lynch beat the market with a highly diversified fund – a feat that is hard to duplicate. The point is that it’s a lot easier to beat the street with a focused portfolio.
15. In every industry and every region, the observant amateur can find great growth companies long before the professionals have discovered them.
Lynch still has a point, even with the amount of information we have today.
Usually, smaller companies have less following by fund managers and analysts, which may offer great investment opportunities.
Again, it requires quite a bit of effort and skill to skim through companies, but it can be more than worth it.
It’s worth remembering though, that an amateur investor rarely finds something that professionals may have missed in big companies like Apple or Amazon.
The amount of information on the biggest companies is so vast that it’s hard to find something that no one else has noticed.
Instead, it may be wise to focus on smaller companies, where there’s a lot of uncharted territory.
16. A stock-market decline is as routine as a January blizzard in Colorado. If you’re prepared, it can’t hurt you. A decline is a great opportunity to pick up the bargains left behind by investors who are fleeing the storm in panic.
This is Lynch’s version of the age-old wisdom of being greedy when others are fearful.
“Being prepared” most likely refers to having no or little leverage and an ample stash of cash to make purchases at a cheaper price.
Of course, if you buy more of the stocks you own, your initial investment decision must be correct. There’s nothing to win in investing more in a bad company.
You should always remember that when you buy a stock, you expect its price goes up. The one who sold the stock expects the opposite. Make sure to check in on opposite views also, there might be things that you have missed.
17. Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether.
Panic selling is probably the most common mistake investors make.
It’s worth remembering, that not only beginners make the mistake of panic selling. Even the most experienced, long-term investors may resort to panic amid a strong market correction.
Successful long-term investing is mostly a psychological feat. Mathematics and all that can be done by practically anyone. It’s the years of discipline and patience that usually proves to be too much to bear for most.
If you possess a great amount of wisdom and can admit to yourself that stock picking is not for you, there’s nothing wrong with investing in funds. In fact, you will probably do better than most in the long run.
If you do, however, feel that you want to pick your stocks, there are a couple of ways to prevent panic.
The best thing is to define your risk level correctly. When you don’t take too much risk, you rarely panic.
The second-best thing to avoid panicking is to have a deep knowledge of the companies you invest in. The more you know, the less you panic.
18. There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of newscasters. Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.
This one is especially important during a bear market when every prediction is worse than the last.
It’s important to remember that when you’re reading financial news, you are the product.
More often than not, the reality isn’t quite as bad as the headlines make it out to be. The grimmer the news is the more they sell.
Also, day-to-day news doesn’t really matter for a long-time investor – quarterly and annual reports do.
A great investor knows how to separate vital information from useless noise.
19. Nobody can predict the interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.
Predicting the direction of the economy is impossible because there is an endless number of factors that affect the economy. You shouldn’t base your investment decisions on predictions.
Still, it is useful to stay informed of macroeconomic factors and how they affect the companies you own.
Sometimes, like during a period of high inflation, economic downturns can be a great opportunity to buy more of a company that has been temporarily hit hard by rising costs.
Eventually, a good company will be able to transfer the rising costs to its prices, which makes the stock price rise again.
So, investment decisions shouldn’t be based on economic forecasts alone, but I would say understanding them is quite important.
20. If you study 10 companies, you’ll find one for which the story is better than expected. If you study 50, you’ll find five. There are always pleasant surprises to be found in the stock market.
Lynch is absolutely correct here. There is always something to invest in, no matter what situation is going on in the market.
Usually, investors tend to focus on whether the market is going up or down, whether is it a bear or bull market and so on.
What might be a better use of time is to focus on the companies. Regardless of what situation the market happens to be in, there are always companies that, on average, do better than others.
Obviously, skimming through companies requires a lot of time and effort, but it’s well worth it in the end.
21. If you don’t study any companies, you have the same chance of success buying stocks as you do in a poker game if you bet without looking at your cards.
This is basically what Benjamin Graham meant back in the day when he separated speculating from investing.
Investing is making a well-informed decision about a company that you have thoroughly analyzed and deemed to be a good investment.
Speculating is buying a stock without analyzing the company. Investing requires knowledge, speculating only requires money.
The more knowledge you have, the less risk you take. The less you know, the more diversified you should be.
If you have zero knowledge when buying a company’s stock, you’re relying completely on luck.
22. Time is on your side when you own shares of superior companies. You can afford to be patient – even if you missed Wal-Mart in the first five years, it was a great stock to own in the next five years. Time is against you when you own options.
This one’s also hard to argue. The key to making money is obviously owning superior companies rather than inferior.
Of course, the hard part is to pick the best companies. It’s quite easy to recognize the winners afterward when everything has gone well.
A lot harder thing is to analyze the fundamental of a growth company and decide whether it will grow to be a superior company or not.
If and when you find a company that truly is superior, you have a very wide window of opportunity. Even if you don’t buy the stock for quite some time, there’s still a lot of profits left to have.
The last sentence about options reveals that Lynch doesn’t recommend options for investors. For most, and especially beginner investors, neither do I.
Trading options requires quite a lot of specified knowledge and experience. If you invest in options, you have to make sure you really know what you’re doing.
23. If you have the stomach for stocks, but neither the time nor the inclination to do the homework, invest in equity mutual funds.
It’s not surprising that one of the most successful fund managers of all time recommends fund investing.
Of course, investing regularly in funds is quite often the best choice, if you don’t want to pick stocks yourself.
The easiest investing solution is to pick a couple of passive index funds and start investing regularly.
By investing regularly in well-diversified funds, you don’t have to worry about firm-specific factors or overall market movements.
Though, even in fund investing, there are pitfalls. Make sure you avoid the most common mistakes in regular investing.
Now, it doesn’t have to be an index fund. You can always invest in normal equity mutual funds.
It’s just that the kind of index funds we have nowadays didn’t exist back in Lynch’s days.
There’s also nothing stopping you from investing in both. You can get the average return from an index fund and strive for higher returns from actively managed funds.
24. Among the major stock markets of the world, the U.S. market ranks eighth in total return over the past decade (written in 1993). You can take advantage of the faster-growing economies by investing some portion of your assets in an overseas fund with a good record.
Thinking in hindsight, this happened to be extremely good advice. It’s not sure which countries Lynch was referring to, but it’s fair to assume China would’ve been the number one candidate.
Of course, the U.S. market has been one of the most profitable ones in the world, so you would’ve done great by investing in the U.S. alone.
Back in the 1990s investors didn’t diversify across different countries as freely as they do nowadays. When index funds became widely available, they offered a whole new world of opportunities.
It’s usually a good idea to diversify your investments across different markets. The main portion of your capital can be allocated to steadier and developed markets like the U.S., and a smaller portion to developing countries that might offer higher returns and diversifying benefits.
25. In the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money-market account. In the long run, a portfolio of poorly chosen stocks won’t outperform the money left under the mattress.
In other words, investing in stocks is the best way to make long-term profits, but only if you do it well.
If you invest in single stocks, you need to have the skills to pick the companies that are most likely to succeed in the long term.
When you keep money in your bank account, it’s guaranteed to go down in value because of inflation. On the other hand, the consequences will be much more severe when you invest your savings in unsuccessful companies.
If you’re not keen on picking your stocks, you can always invest in index funds. This way you will most likely beat the mattress-investing and bond investments in the long run.
Of course, you can consider investing in mixed funds, which have both bonds and stocks in them. These tend to be a bit on the expensive side but are still quite popular among investors.
Summary
Overall, Lynch’s golden rules for investing around a few core lessons:
o Know what you own – do your homework.
o Be a long-term investor
o Avoid too much risk and long-shot investments
o You can beat the market by picking stocks
So, as we can clearly see, Lynch is a long-term stock-picker by heart. He wholeheartedly believes that an individual investor can beat the professionals and the market.
Considering that Lynch beat the market as a fund manager – the toughest finance profession there is – it would be safe to assume that it’s possible for everyone else too.
On average, most of us won’t beat the street. It’s simply not possible for everyone to win.
Picking your stocks requires a tremendous amount of work and dedication, but it’s well worth it.
It’s also worth remembering that the biggest losses in stocks usually come when an investor doesn’t fully understand what he’s invested in – so always know what you own!
