This article is an excerpt from the Shortform book guide to "One Up On Wall Street" by Peter Lynch. Shortform has the world's best summaries and analyses of books you should be reading.
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Are you an independent investor? What are some things you can do to increase your investment earnings?
According to former mutual fund manager Peter Lynch, you have a better chance of success investing independently than through professionals and firms. If you choose to invest independently, however, you must be aware of certain key rules.
Here are six stock market rules for independent investors.
Rule #1: There’s Inherent Risk Involved in Investing
The first stock market rule you have to accept is that investing in stocks entails a great degree of risk—if you’re not OK with that risk, you probably shouldn’t invest, writes Lynch. You may not make a huge return each year, and some years, you may even lose money. However, if you understand this, you can develop the discipline and resilience to stick with your stocks through their ups and downs (rather than selling at the first sign of a downturn), thereby increasing your chances of making a good return on your investment.
(Shortform note: To increase your tolerance for risk in the marketplace, consider allocating some money toward an emergency fund or short-term savings account. Having such a fund provides peace of mind when the market’s doing badly and keeps you from rashly withdrawing investments, which Lynch warns against. Your emergency or short-term fund should contain enough money to support you for three to six months.)
Lynch notes that you can further reduce the risks you’re exposed to by educating yourself about the market and developing good investment skills. You might do this by reading books, scouring the financial section of the newspaper, or talking with people who are already savvy investors. You’ll then better understand what qualifies as a successful portfolio and not aim for impossible gains by making unsound investments.
(Shortform note: While there’s truth in Lynch’s recommendation to educate yourself about the market to have the most success, it may also be the case that you should simply start investing, make mistakes, and learn from them. This is because you’re more likely to remember lessons you learned yourself through trial and error than to remember lessons you learned from a book. Investing yourself will likely also give you a firmer sense of success and failure in the market, allowing you to correct your expectations of how much you’ll make.)
Rule #2: You Want to Nab the Tenfold Increaser
According to Lynch, as an investor, your goal should be to find a tenfold increaser (what he calls a tenbagger): a stock that makes you back 10 times what you invested. A tenfold increaser dramatically improves your return and helps erase the effect of a bad investment. You can find such companies anywhere and probably encounter two to three a year in daily life.
(Shortform note: If you’re an ambitious investor, you might even want to look for “multi-baggers”: stocks that return over 10 times the initial investment. However, most stocks considered multi-baggers these days are companies Lynch would probably advise against investing in because they’re not companies you encounter in your everyday life (and that you can understand easily—a point of Lynch’s we’ll cover later in this guide). For instance, Yahoo! Finance recommends investing in Occidental Petroleum Corporation, “an American hydrocarbon exploration company.” It’s unlikely the average investor has a firm understanding of what this company does and would therefore struggle to follow the company’s progress.)
Rule #3: Only Invest Money You Won’t Miss
Only invest money whose loss won’t negatively affect your day-to-day comfort, stresses Lynch. This is because you can’t predict how stocks will perform in the short term (though you can typically predict over 10 to 20 years) and may temporarily lose money you need to survive.
(Shortform note: If you’re still unsure of how much to invest so your daily comfort won’t be negatively affected, consider applying the 50/30/20 rule: setting aside 50% of your after-tax earnings for needs, 30% for wants, and 20% for savings and investments. This ensures that even in a temporarily unstable market, you’ll have enough to get by.)
Rule #4: Pay Attention to the Company, Not the Market
When you find a company you like, disregard what the market’s doing and just buy stocks now, insists Lynch. This is because 1) the market will always be in flux and will eventually reverse itself, and 2) any pundit or acquaintance who thinks they know how the market will perform is likely wrong: It’s virtually impossible to predict the market’s future movements accurately. Therefore, it doesn’t make sense to act based on the market—instead, act based on how you think the stock will do. If the company’s strong, it will do well in the long term, regardless of what the market’s doing right now.
(Shortform note: In The Intelligent Investor, Benjamin Graham provides context on why investors love thinking about and acting on market movements—the thing Lynch strongly recommends you don’t do. For one thing, investors desire a sense of control over the market and dislike the inertia of waiting for the market to change in their favor. Additionally, it requires less thought to simply guess when a market’s at its lowest or highest point than to do thorough research on a company.)
Rule #5: There Are Different Types of Stocks
Companies fall into one of six stock types and often change type over time, says Lynch. How you invest in a stock depends on what type of stock it is, and it’s important to understand the type before you invest. This ensures you have correct expectations of that company’s performance and won’t sell a stock in a company type prematurely.
(Shortform note: Lynch stresses the importance of managing your expectations of your stock performance by understanding the maximum possible performance of the stock. Expectation management is an important skill to build and apply in all realms of life, including investing, to avoid difficulty and conflict. One piece of advice on managing expectations at work is to never assume you or others fully understand a project or topic of conversation—always seek clarification to ensure everyone’s on the same page. You might apply this advice to your trading: Never assume you know what an unfamiliar piece of information about a stock means and instead seek full clarification.)
Here are the stock types Lynch lists:
Slow-growth companies: Most companies that start out as fast growers eventually become slow growers. Lynch doesn’t particularly recommend investing in slow-growth companies because you won’t make money fast.
Dependable companies: These are large, established companies that grow more quickly than slow-growth companies but still maintain a relatively slow pace. It’s good to have a few dependables in your portfolio because they’ll keep you afloat in market downswings since they generally aren’t as strongly impacted by such swings as smaller companies are.
Fast-growth companies: These companies are small and grow aggressively, at 20 to 25% per year. Such companies also tend to be tenbaggers or higher. These companies are riskier than dependable companies.
Cycle companies: These are companies that grow and contract in cycles. Such companies can be dangerous for inexperienced investors if they don’t understand when’s the best time to invest and that a downswing will be followed by an upswing.
Underdog companies: These are companies that are experiencing a low-growth moment but will soon make a rapid comeback and are therefore worth investing in when stocks are low.
Hidden-treasure companies: These are companies that have an asset you happen to know about but which professional investors have overlooked. An asset might be cash, real estate, a subscription model, or some other hidden advantage. It takes inside knowledge to know this advantage.
Most companies change stock types over time. Fast-growth companies eventually slow down or might become cycle companies. Alternatively, a slow-growth company might become an asset play when clued-in investors recognize it owns good real estate. Any slow-growth company might become an underdog.
#6: Plan to Be in the Stock Market for Life
Lynch advises you to put a fixed amount of money in the market and behave as though that money will always be invested. This assumption will keep you from unwisely withdrawing money from the market in a panic.
(Shortform note: Aside from the missed gains Lynch alludes to, when you withdraw from the market, you must also pay a capital gain tax on your withdrawal. That tax rate can be as high as 20%, making it important to think carefully about withdrawing.)
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- 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