What is Peter Lynch’s investing strategy? What kind of stocks should you buy, according to Lynch?
Peter Lynch is a legendary investor and former manager of the Fidelity Magellan Fund. In his book One Up on Wall Street, Lynch shares his advice on how to win in the stock market. His formula is simple: build a portfolio of stocks based on your risk tolerance, ignore hype, and trust your own judgment.
Let’s look at Peter Lynch’s advice for stock market investors.
1. Buy as Many Stocks as Companies You Understand
Lynch believes you should buy as many stocks as you feel you have special knowledge in or which you’ve thoroughly researched and have faith in. For instance, if you work in the automotive industry, you might have special knowledge about a car manufacturer, or you’ve done extensive research on a new coffee shop chain that’s opened in your area, and you feel confident about its prospects. You’d thus buy stocks in both.
(Shortform note: There’s another compelling reason to buy stocks in only companies you have special knowledge about: Advisors and analysts who claim to understand more than you do about a company usually obtain their information from the company itself. These company performance forecasts are 1) often merely estimates and 2) often inflated to make the company look good.)
If you want a specific number, Lynch recommends acquiring between three and 10 stocks. It’s advantageous to own multiple stocks because the more you own, the more likely you are to snag a tenfold increaser. Further, when you own multiple stocks, you can shift your money around between them, which we’ll talk about in a coming section.
(Shortform note: Others disagree with Lynch’s stock quantity recommendation, instead advising you to acquire at least 20 stocks. While Lynch argues you should own multiple stocks to increase your chances of finding a tenfold increaser, others argue your actual goal should be to diversify your portfolio to mitigate risk, and therefore the more stocks you own, the more likely you are to end up profiting.)
2. Build Your Portfolio Based on Your Risk Tolerance
To create a portfolio you feel comfortable with, take into account the risk and gain associated with each stock type, recommends Lynch. Then, acquire stock types that give you a risk vs. gain ratio you can live with. The risk versus gain ratio for each company type is:
Low risk, low gain: Slow-growth companies
Low risk, moderate gain: Dependable companies
Low risk, high gain: Hidden-treasure companies (provided you’re sure of the company’s assets) and cycle companies (provided you understand the company’s cycles)
High risk, high gain: Fast-growth companies or underdog companies
3. Understand When to Buy and Sell
Lynch claims you should buy stocks when you feel 1) the company’s strong and 2) that you’re paying a fair price for what you’re getting.
Additionally, there are specific occasions when stocks come at a bargain. The first is at the end of the year, when companies sell off many of their stocks and you can snap them up cheap. The second is whenever the stock market’s doing badly. Though you might be tempted to sell at such times to minimize your losses, counteract your instincts and buy while stocks are cheap.
When it comes to selling stock, try to avoid selling too soon whenever possible. Lynch lists many instances in which he took poor advice and sold a stock that continued growing.
4. Re-evaluate Stocks and Shift Money Sensibly Between Them
Lynch recommends that you sensibly move funds between stocks as company situations change, and that you maintain approximately the same distribution of stock types in your porfolio.
For instance, you might wish to maintain three dependable, two fast-growth, and one slow-growth company in your portfolio. Then, if you believe a cycle company has hit its financial peak and that its fortunes will soon reverse, sell that stock and buy stock in a different cycle company that’s about to be on the upswing.
5. Take Your Own Counsel on How to Manage Your Portfolio
Lynch’s final advice on managing your portfolio is to avoid selling just because prognosticators recommend it. Instead, rely more on your research and your continued check-ins on the company to inform your selling decisions. Only when you know specifically that an external circumstance will negatively affect the company should you do something about it.
Similarly, don’t heed platitudes or beliefs about when to buy and sell (things like, “It’s always darkest before the dawn,” or “If it’s this low, it can’t possibly go any lower”). There simply is never a single rule that works in every circumstance, so you’re better off using your knowledge of the company acquired through research.
(Shortform note: Peter Lynch’s advice to ignore hype and go your own way as an investor was largely ignored in the lead-up to the 2007 and 2008 financial crisis. According to Michael Lewis in The Big Short, major Wall Street investment firms fell prey to the contagious excitement about mortgage-backed securities and suffered tremendous losses when the housing bubble burst. Meanwhile, a few iconoclasts who did their basic research and refused to follow the herd profited from Wall Street’s greed and ignorance. In this case, the iconoclasts knew not about an external circumstance that would profoundly affect the stock market, but about an internal circumstance: the risky behaviors of countless Wall Street firms.)
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Here's what you'll find in our full One Up On Wall Street summary:
- Why individuals fare better in the stock market than professionals and firms
- A no-nonsense approach to the stock market
- Why you shouldn't follow the complex predictions of so-called professionals