What should you consider when selecting stocks to invest in? How can you keep each investment from being a shot in the dark?
Famed mutual fund manager Peter Lynch lauds the advantages of stocks over bonds. In his book Beating the Street, he shares suggestions for constructing a successful stock portfolio that’s more likely to perform well over the long haul.
Continue reading for Lynch’s advice on how to select stocks for long-term investment.
How to Select Stocks
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. In his advice on how to select stocks for long-term investment, he explains that it requires researching the financial and market fundamentals of the companies whose stocks you buy.
|Alternate View: Focus on Overall Market Data, Not Specific Stocks
Some successful investors have taken the opposite approach from Lynch—forgoing detailed analysis of individual companies and instead focusing on large-scale, market-wide price fluctuations. In The Man Who Solved the Market, Gregory Zuckerman tells the story of Jim Simons, a former mathematician who became one of the most successful hedge fund managers in history. The key to Simons’s success, writes Zuckerman, was his insight that price fluctuations within financial markets followed recognizable and predictable patterns. When identified, these patterns could be used to strategically buy and sell the right stocks, bonds, currencies, and other financial instruments at the right time.
For Simons, it wasn’t necessary to know anything substantive about the underlying stocks, bonds, commodities, or currencies being traded or why their prices fluctuated the way they did: What mattered was the integrity of the data and the reliability of the patterns identified by his trading algorithm. If the algorithm could detect a non-random pattern and make bets that paid off more often than not, the fund would invest even if it followed no apparent economic logic.
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.
|Fundamental vs. Technical Analysis
Lynch’s approach of rigorously analyzing individual companies and stocks speaks to the differences between two schools of investing thought: fundamental analysis and technical analysis.
Fundamental analysis is the more traditional approach, which Lynch advocates. This school of thought attempts to measure the intrinsic value of a stock. Adherents of this philosophy seek to answer why a particular stock goes up or down in value. They do this, as the name suggests, by delving into the “fundamentals” of the company behind the stock. They’ll look at sector-wide trends and the company’s earnings, expenses, assets, and liabilities to make predictions about what the stock will do.
Technical analysis, on the other hand, identifies trends and correlations—how a particular stock goes up or down in value. It’s much closer to what Simons and his colleagues did, as detailed in The Man Who Solved the Market. Technical analysts assume that the “fundamentals” are already factored into the stock price, so it’s a waste of time and effort to analyze them. Instead, they use mathematical analysis to identify patterns and trends within the market and across different types of financial instruments (like stocks, bonds, commodities, and currencies). These trends can signal what a stock will do in the future.
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.
|What’s the “Right” Number of Stocks to Own?
Although Lynch recommends keeping a small portfolio so you’ll be able to manage and oversee the stocks in it, there are risks to this approach. In a small portfolio, it takes just a few stocks with low returns to drag your entire position down. Similarly, your portfolio can become overly dependent on just a few high performers. For these reasons, some research suggests that the right number of stocks to hold in a well-diversified portfolio is 25 to 30 companies.
In determining how many stocks you should own at once, investment experts also advise that it depends on your stage in life, your investment goals, and your personal risk tolerance. Someone in their 20s may be more comfortable with a relatively small portfolio of only a dozen or so stocks. Although this will likely be a more volatile portfolio because it’s more subject to the ups and downs of just a few companies, at this age you have enough time left before retirement to ride out the short-term fluctuations. Meanwhile, someone nearing retirement may want to hold a larger portfolio of around 30 stocks to reduce the risk of loss if one or two stocks decline.