Have you always wanted to invest in the stock market but felt too uninformed or inexperienced to do so? In One Up on Wall Street, legendary investor and former manager of the Fidelity Magellan Fund Peter Lynch argues that you not only have all the tools you need to become a savvy investor but that you actually have a better chance of investing successfully than professionals and firms: You can act independently and based on your own good information.
Lynch describes a no-nonsense approach to the stock market that involves examining your daily life for investment opportunities, doing your research, and diligently monitoring your portfolio over time. Rather than following the complex predictions of so-called professionals or leaping on the latest and greatest overpriced stock, he advises you to keep your own counsel, be self-reliant, and see yourself as your greatest resource.
Lynch insists that you already have everything you need to do well in the stock market and that you don’t need the services or guidance of a professional investor. He believes this is the case because:
(Shortform note: Others agree with Lynch that you don’t need the guidance of a professional when investing. In The Simple Path to Wealth, J.L. Collins even asserts that firms make investing seem complex to convince potential clients they need a firm’s expertise.)
Lynch argues that professional investors can lead you astray because they’re often misguided or operating from high-minded theories, rather than on-the-ground experience.
(Shortform note: What exactly is a professional investor? The term can apply to day traders, people who trade stocks in their portfolios as a career and chief source of income. However, the term more commonly applies to financial advisors who advise a set of clients and help them develop a better portfolio.)
In part, this is because professional investors face the following obstacles, according to Lynch:
Delays: Most professional investors only buy stock once other investors or firms have done so, and it’s therefore a proven good investment. This means they’re not free to leap on early opportunities, when the stock price is low.
Reputation management: Professional investors have a greater incentive to stick to safe, established companies because they risk less professionally. Investment firms also often like to prioritize parity over profit, spreading investment success somewhat equally among clients so clients don’t become upset if others’ portfolios do better than theirs. The result is that when you allow an investment firm to make investing decisions for you, you’ll likely only ever make moderate gains.
Restrictions on what they can buy: Many investment firms don’t invest in companies that have unions, operate in certain industries, or follow other relatively arbitrary rules. Further, the SEC imposes restrictions on what firms can buy. This limits the range of companies they’ll invest in for your benefit.
Overcoming Obstacles to Investing: Hedge Funds
The delays and inefficiencies Lynch mentions are less of a problem for hedge funds, which exploded in popularity in the 1990s and early 2000s and exist as an alternative to mutual funds. Both hedge and mutual funds are portfolios that an investor manages for clients based on a specific strategy. However, while anyone can invest in a mutual fund, only high-net-worth investors can invest in hedge funds, making them private.
Hedge funds, though now somewhat suspect organizations in the eye of the general public as a result of recent instances of illegal insider trading, have several advantages over, for instance, mutual funds:
First, hedge funds are funds open only to “sophisticated investors"—in other words, high-wealth investors. Because such investors have more financial flexibility than the average person (and because they’re considered to be savvier investors than the average person), there are virtually no restrictions on hedge fund investments—as long as the managers remain within the confines of legality. Thus, hedge fund managers have tremendous freedom in how, when, and what they invest in and what strategies they employ to do so (and these strategies tend to be quite risky).
Further, hedge fund managers are considered to be more astute and connected than the average investor. Many hedge funds hire people with PhDs to increase their competitive and intellectual advantage and constantly strengthen ties to people and organizations with power or information. For this reason, a hedge fund doesn’t have to work as hard to maintain its reputation—and in fact, its reputation is based more on its ability to engage in smart, risky behavior than safe behavior.
When you invest yourself, you have the advantage of being a consumer who can learn about and test a company’s products or services on a daily basis, either in your personal life or at work. This gives you first-hand knowledge of a company’s output.
(Shortform note: As a consumer of a product or service, you may even have an additional advantage: Your consumer feedback, if incorporated, can actively improve a product and thereby improve a company’s prospects on the stock market.)
You’re also an independent entity who can make your own choices on your own timeline, continues Lynch. This lets you potentially make more money on small yet promising companies you come across long before investment firms learn about and act on them.
(Shortform note: While as an independent investor, you have the advantage of being able to make your own choices, many investors enter the stock market precisely because they’re not fully independent: They have children whose college educations they must pay. Therefore, while invested parents may like to leap on small, promising opportunities they come across in daily life, they may also feel pressure to follow the herd, thinking this route is less risky.)
Even though you’re equal to or better than any professional investor, you must be aware of certain key truths to have success and feel in control on the stock market, stresses Lynch.
Investing is inherently risky—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.)
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.)
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.)
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.)
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.
(Shortform note: While Lynch frames slowed growth as an unfortunate eventuality for fast-growth companies, others advise fast-growth companies to actually consider slowing their growth. This is because doing so can help the company firm up its foundation, set realistic goals, and predict future events—and all this can help it maintain momentum in the long run.)
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.
(Shortform note: In The Intelligent Investor, Graham strongly recommends investing in dependable companies, which he describes as large, prominent companies with conservative financing. Graham clarifies that such a company should have at least $10 billion in market capitalization, be an industry leader, and have a market capitalization no greater than twice its value.)
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.
(Shortform note: Fast-growth companies these days tend to be tech start-ups. Such companies are almost compelled to grow extremely aggressively because the first mover generally captures the entire market, making speed more important than careful planning.)
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.
(Shortform note: Lynch discusses cycle and underdog stocks but doesn’t explain how to identify them or how to know when they’re about to resurge. This may raise the question: Wouldn't a person with more education on these matters—for example, an MBA in finance—have an advantage as an investor? And, assuming the answer is yes, does that point to a flaw in Lynch's argument that an average person can have as much success as a professional investor?)
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.
(Shortform note: In Naked Economics, Charles Wheelan goes against Lynch’s belief in hidden-treasure companies by asserting that it’s unlikely that you’ll ever have special information about a company that other investors don’t have. This is simply because there are too many investors out there looking for the same hidden treasures as you.)
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.
(Shortform note: Where can you find information about changes in a company’s stock type so you can make savvy trading decisions? These days, there are a variety of sites and apps that can keep you updated (though these won’t specifically tell you when a company changes stock type, as stock types are a construct of Lynch’s; rather, they’ll provide news about a company’s fortunes so you can draw your own conclusions about how its type is changing): The Wall Street Journal app, the Bloomberg: Business News Daily app, and TheStreet - Investing News app are just a few.)
An Alternative to Stocks: Cryptocurrency
Beyond the stock types Lynch mentions here, there’s an entirely different type of investment that’s emerged and grown popular in the last few decades: cryptocurrency, a digital currency you can trade like stocks.
Buying cryptocurrency, as opposed to company stock, might appeal to you if you have a high risk tolerance: Crypto is generally considered to be a risky investment. You might also wish to invest in crypto if you want to use that asset more flexibly than merely being able to buy and sell it—you can earn profit from non-trading activities like yield farming, and you can extract nonmonetary value from a crypto token (like special access to your favorite sports team).
Still, as appealing as cryptocurrency might seem, it’s likely advisable to invest in both crypto and traditional stocks to diversify your portfolio and mitigate risk.
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.)
Now that you understand how to regard and interact with the stock market, start looking for investment opportunities. Lynch believes you’ll find the best investment opportunities in the places most familiar to you: daily life and work. Familiar companies are best to invest in because you have the greatest odds of understanding them and how well they’ll perform.
For instance, if you regularly order house plants from a great online plant store, you have a strong knowledge of that company, which might make its stocks worth investigating. Similarly, if at work, you deal often with a great printing company, you have inside knowledge of that company—an advantage in deciding if you should invest.
Conversely, Lynch strongly warns against investing in companies you don’t understand, trendy companies everyone else is investing in, companies that are diversifying, or companies that supply to only a single buyer. Such companies are likely to fail sooner or later.
(Shortform note: Not everyone agrees with Lynch about investing in companies you know. In Benjamin Graham’s The Intelligent Investor, financial journalist Jason Zweig writes in commentary that you must never buy stock in a company merely because you like its products. Instead, decide first if the stock is over- or undervalued and then buy or hold off accordingly. While Lynch doesn’t claim that you should buy stock in a company you like without looking into its financials (and in fact advises you to conduct three research steps, which we’ll examine next in this guide), he does think you should only research companies you already know and like. Zweig, on the other hand, seems to think personal preference should matter little or not at all.)
When on the lookout for good investments in your daily life and at work, pay particular attention to companies with the following positive attributes, writes Lynch:
Companies that are—or sound—mundane or unappealing: Unglamorous companies (like waste removal or pest control companies) often do well but don’t attract investor attention until stocks are high. For this reason, investigate companies with boring or unappealing names, as this may indicate the company is uninteresting to most investors and therefore attractive.
(Shortform note: This recommendation may no longer apply in today’s tech-saturated business world. Some argue that every company—no matter what it does—is now a tech company because tech has simply become a necessity for staying competitive. This means that companies that might once have seemed mundane or unappealing 1) can use tech to modernize their operations (like a plumbing company using the latest technology to complete jobs more effectively) and 2) can use tech to easily reach the eyes of more investors (a pest control company might create a flashy social media campaign).)
Companies that have branched off from larger companies: When a subsidiary becomes its own company, it’s often successful because the parent company ensures the subsidiary is in good financial standing beforehand.
(Shortform note: Why would a parent company spin off a new independent company in the first place? One reason may be that the parent company wants to dedicate its resources to only the highest-performing areas of its business and allow a subsidiary to take care of the other areas. Additionally, parent companies expect the spinoffs will be profitable, as these can narrowly focus on one service or product. This is in line with Lynch’s belief that parent companies set up spinoffs for success—parent companies want the spinoff to succeed.)
Companies in no-growth industries: Seek out companies in industries that seem not to be growing at all because this indicates there’s little competition in such industries, and strong companies can flourish.
(Shortform note: While it may seem difficult for any company to grow in a slow-growth industry, business experts agree with Lynch that savvy companies can find ways to excel in even the slowest industries. For instance, they might offer a product that’s superior to all others in quality, cost, or functionality.)
Lynch advises that once you’ve discovered an interesting and viable company, don’t invest right away. First, conduct sound research. This should only take a few hours per stock.
(Shortform note: Others feel you might need to spend more time than a few hours on each stock: To become a true home-grown stock analyst, you might also wish to research a company’s suppliers, customers, and competitors—a process that could take days or weeks.)
Do this in several steps:
The first step of your research is to determine what type of stock you’re looking at, writes Lynch. This is because you might only want to buy a certain type of stock now based on your needs and risk tolerance—for instance, you might reduce risk by investing in a dependable company.
(Shortform note: Rather than letting your current needs and risk tolerance determine what type of stock you buy, investment expert Benjamin Graham proposes determining if you’re an aggressive investor or a defensive investor and letting that identity inform your stock buying decisions. An aggressive investor is eager to obtain better-than-average returns on their investments while a defensive investor simply wants to obtain decent returns. Consider deciding which type of investor you are and then steering toward appropriate stock types (an aggressive investor might favor fast-growth companies while a defensive investor might prefer dependable companies).)
The stock type you determined in the last step tells you what information you need to gather on the stock to evaluate its future success and assure yourself that it’s a worthy investment, writes Lynch. Certain data will only be helpful in evaluating the potential of certain stock types.
While the task of data collection can seem daunting to a novice investor, it’s simpler than you might think. You just need a few pieces of information and a general understanding of how well the company is performing. You can obtain this from the investor-relations department of the company, your broker, company reports, or by visiting the company itself if you can.
(Shortform note: Gathering the data you need to make an intelligent investing decision may seem tedious or boring, if not superfluous. But Benjamin Graham provides a compelling reason to do your due diligence: When you purchase a stock, you become a part-owner of a company. That means you have both the responsibility and the privilege to pay attention to your company’s progress and speak up when you see management making poor decisions. When you take on the perspective of a company owner, gathering data on your business seems critical.)
Here’s the data you should find, says Lynch:
The P/E ratio is the stock Price to company Earnings ratio. You obtain this by dividing the company’s stock price by the company’s earnings per share (essentially how much the company makes per share; this is net profits divided by the number of shares issued).
For instance, if a stock price is $4.00 and the company’s earnings per share are $1.00, the P/E ratio will be ($4.00 : $1.00 =) 4.
Lynch writes that the P/E ratio is helpful for several reasons: You can think of it as the number of years it will take the company to earn back your initial investment. Therefore, a high P/E ratio (20 or 30, for instance) may be unattractive while a low one (say 6 or 7) may be attractive.
(Shortform note: Another way to think about the P/E ratio is that it’s an indicator of what investors are willing to pay today for a stock based on its past earnings or projected future earnings. So if a company has a high P/E today, it might mean that investors expect the company to grow significantly in the future and are willing to pay a high share price now. Therefore, while you can sometimes take a high P/E as a warning sign and a low P/E as an invitation to buy, as Lynch indicates, a high P/E can also be a sign of future growth.)
Lynch also notes that by comparing the P/E ratio to the P/E ratios of other companies in the industry or to that company’s previous P/E ratios, you can see if a stock is priced fairly, too high, or too low. For instance, if a company’s stock currently has a P/E of 20 (stock price of $100/earnings per share earnings of $5) and last year had a P/E of 5 (stock price of $10/earnings per share earnings of $2), you can tell that the stock price is very high now. You might therefore wait until it falls before investing.
(Shortform note: What exactly does it mean for a stock to be “priced too high or too low?” When a stock is priced too high—or overvalued—the company’s projected future earnings don’t justify the high price. In such cases, the stock is expected to drop to more accurately reflect company earnings. In the same way, a stock that’s priced too low—undervalued—sells for less than what it should sell for, based on the company’s performance.)
When looking at P/E ratios to help guide your investing decisions, take into account what type of company it is. You can’t expect the same ratios for dependable companies, fast-growth companies, and slow-growth companies.
(Shortform note: It’s true that you can’t expect to find the same P/E ratios for different types of companies, as the rise of fast-growth technology companies illustrates. Tech companies can have P/E ratios in the hundreds or thousands: The mobile payments company Square recently had a P/E of 1052.75.)
It’s also worth looking at a company’s assets and liabilities on company reports, writes Lynch. You want to see that a company’s assets are growing and that its liabilities (debt) are shrinking over time. It’s also a good sign when the company’s assets are currently greater than its debt—if this is true, the company likely isn’t about to go out of business.
Assets and liabilities won’t give you a detailed view of the company’s financial standing because they only indicate what the company owns and what it owes. However, when you subtract liabilities from assets, the result will tell you if the company is generally doing well or badly: If the result is positive, the company has greater assets than liabilities, and it’s in good shape. If the result is negative, its liabilities are greater than its assets, and it’s not in good shape.
(Shortform note: Lynch advises reviewing a company’s assets and liabilities but doesn’t provide a formal definition of these. Assets are resources or goods a company can use to reduce expenses, generate cash, or provide future economic benefits. For instance, your car is a personal asset because you can sell it to generate cash. A patent might be an asset for a company because it provides future economic benefits. Liabilities, on the other hand, are financial obligations to other parties. These include loans, mortgages, accounts payable, deferred revenues, and more. For instance, a company’s payroll is a liability: It’s money it owes its employees.)
A dividend is the money a company regularly pays to shareholders, explains Lynch. (It’s different from capital gains, which is the profit you make from selling a stock at a higher price than the price at which you bought it.) Not all stocks pay dividends, so you may prefer stocks that do if you like receiving a regular payout. Conversely, you may prefer stocks that don’t pay dividends because these companies can invest that money into growth, which might result in greater capital gains later. Lynch himself prefers to invest in fast-growing companies that don’t pay dividends over slow-growing companies that do.
Companies’ Changing Approach to Dividends
Lynch’s preference for investing in fast-growing companies that don’t pay dividends reflects the change in how companies approach dividends that occurred over the 20th century. According to Graham in The Intelligent Investor, companies used to pass on most of their profits to shareholders in the form of dividends. This meant that you could tell a successful company by its large dividend payments.
However, later in the century, companies paid less in dividends and retained more of their profits to pour into growth. This meant that investors started considering a company paying dividends to be a bad sign—a signal that the company wasn’t growing.
Still, there’s reason to be cautious when a company pays no dividends: They might not be investing their profits in growth, but rather in poorly conceived projects or acquisitions. View dividends merely as a piece of the research puzzle, and don’t invest simply because a company does or doesn’t pay dividends.
Once you’ve examined the company’s P/E ratio, assets and liabilities, and dividends, find answers to these additional questions about the company:
Identify if the company has certain types of valuable special assets because this can make the stock more valuable, writes Lynch. Special assets can be natural resources (precious metals, oil, land, and so on), brand recognition (think of Starbucks or Tesla), real estate, patents on drugs, ownership of TV and radio stations, or tax breaks.
(Shortform note: A different way to consider whether a company has special assets is to identify what experts call its unique selling proposition—what makes the business unique among competitors. Ask, Is this company doing something no other company can easily do? What about this company’s business model, product, or operations can’t easily be duplicated and therefore makes the company valuable? If you have positive answers to the above questions, you can consider the company to have a special asset.)
Lynch warns that you should be wary of companies that recently acquired another company. Often, a large company will do this hoping to increase its profits, but the resulting merger often fails to improve the parent company's finances. This may be because 1) the parent company overpays for the deal, or 2) the parent company doesn’t understand the company it just purchased. The result is that the company often ends up selling off unprofitable acquisitions by restructuring. This cycle tends to repeat itself and is bad for investors.
(Shortform note: It’s likely also advisable to pay attention when a company is in the planning stages of an acquisition or merger. In 10% of cases, such deals fall through, which can have undesirable consequences for both the companies and the shareholders. In fact, 3% of the time, activist investors (usually hedge funds) bring the deal to a standstill, showing that investors often view acquisitions as dangerous.)
It’s a good sign when a company buys back its own shares, asserts Lynch. By doing this, they take shares off the market. When there are fewer shares, demand drives the share price up—a boon for those already or soon-to-be invested in the company.
(Shortform note: Why would a company buy back its own stocks? There are several reasons, one of which is that the company feels its stocks are undervalued and wants to drive up that value. Another reason is that, by buying up stocks and reducing the number of outstanding shares, the company’s earnings per share (which we mentioned in our discussion of the P/E ratio) increases, making it look more appealing to investors—without the company actually having to increase its earnings. So while Lynch points to companies buying their shares as a good sign, it might also simply be the company’s way of making itself look better without making significant changes.)
Similarly, when employees buy their own company stock, it means they have faith in the company—another good sign.
(Shortform note: While employees purchasing company stock may well be a good sign for you as an investor, surveys show that few employees participate in such employee stock purchase plans. Therefore, it’s probably best not to rely too much on this metric.)
If a company—especially a retailer or a manufacturer—has a large inventory, it usually means it isn’t selling as much as it would like to, contends Lynch. Further, this inventory will depreciate in value and can’t be sold for as much in the future—think about clothing, which rapidly depreciates because it goes out of style. Consider avoiding such companies.
(Shortform note: Since the book’s publication, product life cycles have become even shorter, which means inventory becomes obsolete faster than before. This is due in part to technological advancements and rising consumer expectations. What’s more, some tech companies, like Apple, implement planned obsolescences—making new operating systems incompatible with older devices. This forces consumers to constantly upgrade to the latest models and makes old models valueless.)
Lynch recommends that if you’ve answered the above questions and satisfied yourself that the company’s financials are sound, the final step of assessing and researching a stock is to devise a two-minute monologue describing why the company’s worth investing in, which you can say to yourself or to someone else. This practice firms up the reason for buying the stock in your mind or helps you question that reason if it’s unsound.
(Shortform note: Lynch’s logic here is that by creating a speech about why you should invest in a company, you force yourself to carefully think through and justify those reasons. If this is the main point of crafting a speech, you could also simply write down the monologue without reciting it. This is because writing something down forces you to think deeply about the topic and aids recall—no recitation necessary.)
After you’ve created your monologue about why to invest in a company and then actually invested, periodically check that the reasons you invested still stand, insists Lynch. Monitor your stocks carefully, and adjust your investments depending on your stocks’ fortunes.
(Shortform note: If you don’t see yourself periodically checking on your investments, consider investing not in individual stocks but in index funds: stock portfolios that are designed to perform the same as a financial market index—for instance, the Standard & Poor’s 500 Index. According to Burton G. Malkiel in A Random Walk Down Wall Street, this is the best and safest strategy for any investor.)
You may by now have purchased your first stock, which means it’s time to begin thinking about building a long-term stock portfolio. Let’s look at Lynch’s advice on how to manage a portfolio over a lifetime.
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.)
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
Building a Low-Risk Stock Portfolio
Lynch recommends building a portfolio that reflects your tolerance for risk. Indeed, in I Will Teach You to Be Rich, Ramit Sethi recommends doing the same thing—what he calls diversifying your portfolio: distributing risk among various types of stocks. He adds that distributing your assets intelligently to mitigate risk is more important than finding perfect companies to invest in. Therefore, you might spend more time thinking about the risk distribution of your portfolio than researching a particular company.
Sethi also breaks stocks into different categories than Lynch and recommends investing not in slow-growth or dependable companies, for instance, but rather in domestic or developed-world international stocks. He specifically recommends using the following asset distribution:
Invest 30% in domestic stocks
Invest 15% in developed-world international stocks
Invest 5% in emerging market stocks
Invest 20% in real estate development trusts
Invest 15% in government bonds
Invest 15% in treasury inflation-protected securities
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.
(Shortform note: Lynch recommends manually monitoring your stocks, but in I Will Teach You to Be Rich, Ramit Sethi argues you should also create automated systems that invest in the stock market regularly for you. This eliminates the need to think about investing every day yet ensures you continue to grow your wealth. Lynch’s and Sethi’s approaches should be seen as complementary, rather than mutually exclusive, though: You can initially determine the stock type breakdown of your portfolio and then set up automatic payments that continue to invest in them. Finally, check on how well your portfolio’s doing and shift funds around as necessary.)
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.
(Shortform note: Lynch advises you to buy and sell when you feel is best based on the company’s financial performance—in other words, to not buy or sell based on the emergence of bull or bear markets, as many investors do. A bull market is a market in which stock prices rise and the economy performs well. Many investors wish to buy stock in bull markets. Conversely, in bear markets, stock prices decline and the economy experiences a downturn. Investors withdraw money from the market, fearing loss.)
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.
(Shortform note: Lynch notes that you should avoid selling early, but how can you tell when it’s too early and when it’s the right time to sell? One metric is media attention: If a company is garnering significant attention in the media, more investors will likely be drawn to the stock, which will drive the price up and eventually may cause it to collapse. You might thus consider selling just when you start reading about the company in the press.)
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: 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.)
Practice using Lynch’s strategy for finding and researching potential investments.
Think back to the last few days: Did you encounter any companies whose product or service piqued your interest? Do any of these companies have one or more of Lynch’s preferred traits—does it have a mundane name or business, exist in a no-growth industry, or is it a spinoff of an existing company? You don’t have to do in-depth research for this exercise—simply jot down your thoughts about the company that seems most promising to you.
Now, reflect on what type of stock it is: a slow-growth, dependable, fast-growth, cycle, underdog, or hidden-treasure company. Again, you don’t have to investigate this in detail for this exercise, but simply use your existing knowledge and a few minutes of online research to place the stock as one of these types.
Next, do a quick online search for the company name and try to find answers to some of Lynch’s questions about the stock: Is the company buying back shares? Has the company recently diversified? Does the company have any special assets? Does it have a large inventory? Note any findings you make below.
Finally, write down a brief speech or paragraph detailing why the company is a good investment opportunity.