Do individual investors have a chance on Wall Street? What are the safest types of investments in the long term?
In Beating the Street, Peter Lynch explores how ordinary investors can outperform the market—and the pricey Wall Street fund managers who assemble stock portfolios. He says that the key is hard work, diligence, and persistence in picking the right stocks to build a winning portfolio.
Continue reading for an overview of Beating the Street by famed mutual fund manager Peter Lynch.
Overview of Beating the Street by Peter Lynch
In Beating the Street, Peter Lynch draws his key insight from his decades of success managing the Magellan Fund at Fidelity. He asserts that all the information anyone needs to become a successful investor is readily available; you just need to be willing to put in the hard work to translate that information into well-researched and timely stock investments.
We’ll explore Lynch’s strategy by which non-professional, individual investors can beat the pros at their own game, looking at:
- Why bonds, despite their reputation as a low-risk investment, offer poorer returns than stocks over the long haul
- Why it’s crucial to do your homework and understand everything about the companies you’re investing in
- The importance of being patient, persistent, and willing to endure the inevitable short-term losses that come from investing in the stock market
Part 1: Beware of Bonds, Trust in Stocks
Lynch writes that, despite their reputation as a riskier and more volatile investment, stocks have significantly outperformed bonds over the long term. We’ll explore the downside of bond investing by first exploring the basics of how bonds work and then detailing some of the main risks that come from investing in them. Then we’ll examine why Lynch advocates stocks as a superior investment.
How Bonds Work
To understand why many investors think bonds are less risky than stocks, it’s useful to briefly explain how bonds work. A bond is a debt obligation issued by a borrower—with the borrower usually being a corporation, a state or municipal government, or the US Treasury. These entities issue bonds to raise capital. When you purchase a bond as an investor, you’re loaning money to the bond issuer, which pays you back with interest.
We can illustrate how bonds work with an example. When you buy a $1,000 bond from the issuer, it typically pays out interest at a fixed rate (the coupon rate) for a specified period of time. At the end of this period, the bond purchaser receives the full $1,000 value of the bond (the face value). So if your one-year $1,000 bond pays out 5% interest, you’ll receive a 5% ($50) interest payment after six months (the coupon date). After one year, the bond will reach its maturity date, when the face value of the bond comes due and you’ll be paid back the $1,000 face value. So, over the course of your investment, you’ll have earned a 5% return on $1,000.
The Risks of Bonds
This simple illustration of bonds makes them seem like an attractive, low-risk, low-stress investment. But, warns Lynch, bonds are actually fraught with risk because their real returns are highly vulnerable to 1) inflation, and 2) interest rate changes.
Inflation Risk
Inflation is when prices rise across the economy. So, a basket of goods that you could buy for $10 last year might cost you $12 under inflationary conditions this year. And, warns Lynch, that spells trouble for fixed-income investments like bonds. Remember, your bond coupon payments will pay the same fixed rate of interest throughout the life of the bond until it reaches maturity. But, if prices are rising during that time, the real purchasing power of those fixed payouts will decline: Your fixed $50 coupon payment buys you less as prices rise.
Interest Rate Changes
Changes in the general interest rate can also erode the value of your bond investment, cautions Lynch. To understand this, we also need to understand that, in addition to holding on to your bond until the maturity date, you can also sell your bond to a third party before it reaches maturity.
But, there’s an inverse relationship between bond prices and interest rates. When interest rates go up, bond prices go down. This is because when interest rates rise, investors have an opportunity to purchase newly issued bonds that pay a higher interest rate. Because they have this opportunity to earn higher bond returns elsewhere, they’re only going to buy your older, lower-interest bond at a discount. So if you want to sell your bond before it reaches maturity, you run the risk of selling it below face value, depending on the interest rate at the time.
Trust in Stocks Over Bonds
These bond risks, writes Lynch, highlight why stocks are the superior investment option over bonds. He writes that the historical performance of the stock market, as measured by popular stock indexes like the S&P 500, Dow Jones Industrial Average, and Nasdaq, shows that sustained investment in stocks yields higher returns than bonds over time. This is because stocks are an equity investment, not a debt investment like bonds. When you open stock in a company, you become a shareholder—a partial owner of that company. And, as a shareholder, you have the opportunity to enjoy both dividends (payments companies make to shareholders out of profits earned) and annual increases in the stock prices themselves.
Lynch cautions that this superior performance is over the long term: In a given quarter or year, bonds may yield higher returns than stocks. But, he emphasizes, over the course of decades, stocks always win out.
Part 2: Selecting and Managing Your Stocks
Now that we understand the advantages of stocks over bonds, it’s time to explore Lynch’s suggestions for how to construct a successful portfolio.
Lynch writes that amateurs can pick stocks as well as—and often better than—professional portfolio managers. But, he cautions, outperforming the pros isn’t easy. It requires researching the financial and market fundamentals of the companies whose stocks you buy. Once you construct that portfolio, he writes it’s important to monitor and manage it effectively: Avoid investing in so many stocks that you can’t keep track of them, do a regular review of your holdings to know which companies’ stocks to dump or buy more of, keep your portfolio diversified, and play the long game.
Understand the Fundamentals
Your job as an investor is to understand the fundamentals behind the companies you invest in, writes Lynch. Picking stocks isn’t supposed to be a game of chance: When you buy a stock, you’re not buying a raffle ticket, hoping that your stock is the “lucky” one that rises in value. Instead, behind every stock is a real company, with managers, employees, products and services, and a business strategy. Your job as an investor is to understand the fundamentals behind the companies you invest in—the products or services they bring to market, their strategy for long-term growth, and their overall financial health. If you’re picking stocks without doing this research, you’re effectively just gambling.
Lynch writes that it’s important to get into the details of a company’s operations before you decide to invest in it. In fact, during his time as a fund manager, Lynch often made a point of visiting the headquarters of companies he was considering adding to the Magellan portfolio and meeting with executives. He wanted to know that a company’s leaders had clear plans for future growth, that a company wasn’t saddled by unsustainable levels of corporate debt, and that the people running the firm were generally competent.
Manage Your Portfolio
Once you’ve figured out which companies’ stock to purchase for your portfolio, Lynch writes that it’s time to turn to how to manage that portfolio. According to Lynch, proper management of your portfolio is key to your success as an investor. He offers some core principles of stock portfolio management:
- Don’t invest in too many companies.
- Pay attention to the companies you invest in.
- Diversify your portfolio.
1) Don’t Invest in Too Many Companies
Crucially, you should never hold more stocks in your portfolio than you can personally manage or keep track of. A manager of a large fund with a staff of analysts can afford to own stock in hundreds or even thousands of companies; however, as a retail investor, you’ll never have the bandwidth to do the research you need to do to make informed investment decisions in a portfolio that large.
2) Pay Attention to Your Stocks
Lynch advises you to pay consistent attention to the stocks in your portfolio. Playing the stock market is not a “set it and forget it” business. Analyzing the key metrics of the companies whose shares you own—quarterly earnings statements, profit and loss statements, balance sheets, and cash flow statements—will help you determine which stocks are poised for sustainable long-term growth and which are overvalued and likely to suffer a decline. Don’t just hold onto a stock by inertia: If the fundamentals of the company are truly headed in the wrong direction, it may be time to sell them.
Lynch writes that it’s best to take copious notes on the activities of the companies in your portfolio. He recommends a review of your full portfolio every six months to evaluate which stocks to drop, which new ones to add, and which current ones to buy more of.
3) Keep Your Portfolio Diversified
Lynch writes that it’s crucial to maintain a balanced portfolio. This means having a mix of stocks from many sectors of the economy. Indeed, warns Lynch, it’s a risky strategy to overload in stocks from companies in any one industry, no matter how stable and secure that sector may seem. Ideally, you want a portfolio whose composition closely reflects the total market—this protects you against a collapse in one industry because your losses there may be offset by gains (or at least smaller losses) in other industries.
Recent history shows why it would be a gamble to bet too heavily in one industry: Putting all your money into tech stocks would have wiped you out during the dot-com crash of the early 2000s; going all-in on cryptocurrency would have been calamitous in 2022 when cryptocurrencies plummeted amid fraud scandals.
4) Play the Long Game
Lynch writes that successfully managing your portfolio is largely about staying the course in the market. Don’t worry about the short-term ups and downs—the historical performance of the market over decades shows that consistently owning stocks is a winning strategy.
When you start buying stocks, you’ll inevitably experience market downturns. They can last for a month, a quarter, or even a couple of years. These downturns are often unpredictable and are usually caused by large-scale macroeconomic events and conditions that individual investors have zero control over—from interest rate changes to geopolitical events to natural forces like weather and pandemics.
And, when these bear markets strike, you’re likely to lose money. But, warns Lynch, this isn’t the time to flee the market in a panic. Indeed, he doesn’t think of them as market collapses at all, but rather as market corrections—times when previously overvalued stocks come back to Earth and settle at prices that more accurately reflect their worth. And it’s during these market corrections that savvy investors can seize the opportunity to find bargains and buy stocks at discount prices. By contrast, writes Lynch, bull markets (when stock prices experience a prolonged rise) are often a sign of overpriced stocks, where you’ll be hard-pressed to find good bargains.
Part 3: The Case for Index Funds
We’ve now explored why you should invest in stocks instead of bonds and how you should build and manage your personal stock portfolio. But, what if you want to get exposure to the stock market without going through the trouble of researching, building, and managing your own portfolio of individual stocks?
Lynch writes that stock funds can offer a good alternative to constructing and maintaining your own stock portfolio. So what are stock funds and how do they work? A stock fund is a type of investment fund that pools money from multiple investors to invest in a selection of stocks. When you buy shares in a stock fund you don’t actually own the underlying stocks—instead, you own shares of the fund itself. The fund manager is responsible for selecting and maintaining the mix of stocks in the fund, which saves you the time and trouble of having to do this.
But, as we’ve seen, Lynch is skeptical of pricey fund managers, who he argues often charge high fees and deliver returns that don’t even beat the average market returns. That’s why he recommends stock index funds as a particular type of stock fund for investors who want to enjoy solid returns without having to manage their own portfolio—or see their returns eaten up by high management fees.
Index funds are stock funds composed of a broad portfolio of stocks that are designed to mirror one of the big market indexes. Many popular index funds at large investment companies like Vanguard, Fidelity, or State Street offer index funds that track well-known market indexes like the S&P 500 or the Dow Jones Industrial Average.
The stocks in an index-tracking mutual fund are automatically selected based on their position in these indexes. You’re not actively managing it, nor is a fund manager. The fund you invest in purchases shares of companies in proportion to those companies’ positions within whichever index the fund is tracking. For example, if the fund you bought into tracks the S&P 500—and Google stock comprises 3% of the total market capitalization of the S&P 500—your fund will have 3% of its holdings in Google stock.
Different Types of Index Funds for Different Investment Needs
Lynch advises that there are many different types of index funds that track different segments of the financial market, depending on where an investor wants to put her money, such as market cap funds, sector-based funds, and regional funds.
Market Cap Index Funds
These are funds that invest in stocks based on those stocks’ total market capitalization (or “market cap”)—the number of shares currently issued multiplied by the price per share. So, for example, a company with one million shares currently issued trading at $50 per share would have a market cap of $50 million. There are funds that invest in large-cap stocks (those with market caps above $10 billion), mid-cap stocks (with market caps between $2 billion and $10 billion), and small-cap stocks (those with market caps between $250 million and $2 billion).
You’d purchase shares in large-cap index funds if you want the relative stability of investing in mature, well-established companies that are more likely to earn steady returns than small companies or startups. On the other hand, you’d invest in medium- or small-cap index funds if you want the potentially high returns that can come from investing in startups and growing companies—and can stomach the higher volatility and risk that can come with it.
Sector-Based Index Funds
There are also index funds that buy stock in companies exclusively in a specific industry or market. For example, a fund may buy shares of companies in sectors like energy, consumer goods, health care, information technology, or real estate. You’d invest in a sector-based fund if you believe that that sector offers higher potential for growth than other sectors of the economy, or if you want to hedge your portfolio if you’ve invested in other sectors.
For example, let’s say you’ve invested heavily in the traditional energy sector (which includes oil companies, natural gas producers, and coal mine operators). You might then want to purchase shares in a renewable energy index fund (which includes companies engaged in wind, solar, hydroelectric, and even nuclear energy), so you can offset potential losses in case the price of oil drops or if the government passes new regulations that restrict fossil fuel production.
Regional Index Funds
There are also index funds that buy shares in companies (often those with the largest market caps across a wide range of industries) that are based in a particular region or country. So, for example, there are funds that trade exclusively in North American, European, Asian, or South American stocks.
You would invest in regional index funds if you believe that a particular region or country’s economy offers the kind of growth you want. If you want more stable, but potentially lower returns, you would perhaps invest in a regional fund that comprises companies from more developed markets, such as North America or Western Europe. If you’re looking for potentially high returns (and can handle higher risk), you might invest in regional index funds composed of stocks from companies in developing parts of the world—such as sub-Saharan Africa or Southeast Asia.
