Peter Lynch’s investing principles from Beating the Street

Editor’s note: This article was first published in July 2022. Its figures come from the book itself, from the early 1990s: the 64-year comparison of 100,000 dollars in government bonds versus the S&P 500, Treasury bills paying up to 14% in the early 1980s, and the claim that up to 75% of equity funds failed to beat their benchmarks.

In his book Beating the Street, the follow-up to his famous One Up on Wall Street, Peter Lynch sets out a number of investing principles in his own distinctive tone. Some of them come with a healthy dose of common sense.

We haven’t included all of them, because some would need to be put in context. Peter Lynch ran the Fidelity Magellan Fund from 1977 to 1990, and in this book he shares his keys to investing, both for choosing a mutual fund and for picking individual stocks. At the end of the article we’ve also included Peter Lynch’s 25 golden rules of investing.

Peter Lynch’s investing principles

Investors who prefer bonds don’t know what they’re missing

There have certainly been periods when bonds have outperformed stocks, but over the long term bonds don’t beat the returns of stocks. Over a total of 64 years analysed by Peter Lynch, an investment of 100,000 dollars in long-term government bonds would have grown to 1.6 million dollars, while the same amount in S&P 500 stocks would be worth 25.5 million dollars.

When government bond yields exceed the S&P 500’s dividend yield by 6% or more, sell your stocks and buy bonds

This is the only one of Peter Lynch’s principles that overrides the previous one. Lynch describes how, at a time when interest rates had reached double digits, as had inflation and unemployment, he included a large percentage of US Treasury bills in his fund for the first time. He didn’t do it as a defensive strategy, but because Treasury bills were paying as much as 14%, which is above what you can expect from the stock market. When a situation like this arises, it makes sense to sell stocks and invest in bonds.

The best stocks to buy may be the ones you already own

At some point we analyse and choose stocks for our portfolio, and they do well. That’s when we start thinking about diversifying our portfolio again in search of new investment opportunities. And that’s where we overlook the fact that the best companies to buy may well be the ones we already hold. In other words, increasing our investment in stocks we already own.

Since you’re choosing a mutual fund, at least choose a good one

As many as 75% of equity funds have been worse than mediocre at beating their benchmark indices. What most investors don’t understand about mutual fund performance is randomness and regression to the mean. These investors tend to choose a fund that has beaten the S&P 500 for three years in a row, only to watch it slump over the next five years. Meanwhile, they overlook other funds that have delivered more modest but steady returns for 20 years. In other cases, given how highly diversified some mutual funds are, it would make sense to invest directly in an index fund, which over the long term has been shown to beat most actively managed funds.

Not all common stocks are equally common

On Wall Street, there are some stocks you almost have to hold if you manage a fund, because they are safe and investors feel comfortable with them. Then there are other stocks that are off Wall Street analysts’ radar, because they belong to small companies that haven’t attracted much attention from fund managers. If you find one of these companies whose sales are rising while its share price is still low, that’s where incredible investment opportunities arise, because it’s only a matter of time before Wall Street notices these companies.

Never bet on a recovery while they’re playing funeral music

There’s nothing wrong with losing money on a stock, just as there’s nothing wrong with averaging down on a stock as it falls. But averaging down on a stock whose fundamentals are deteriorating is usually not a very good idea.

The extravagance of any corporate office is directly proportional to management’s reluctance to reward shareholders

With this, Peter Lynch is telling us that extravagance at the top of any company bodes ill for it. A CEO building a fountain at headquarters, or buying a helicopter, has been linked to a company’s financial problems. When management starts squandering money on extravagances, it’s a bad omen for shareholders.

If you like the store, chances are you’ll love the stock

Lynch tells us that, for investing purposes, the inside of a shopping mall is far more useful than a month of investor conferences. If you watch the stores in a mall, especially the ones with the most foot traffic, you’re already getting information. If, on top of the foot traffic, you like the inside of the store and people are leaving with shopping bags, you have a potential candidate for investment.

When company insiders are buying, it’s a good sign

Nobody has better information than a company’s own directors, executives and other staff, so when these people are buying shares in their own company, it’s a good sign, because they’ll be willing to make an extra effort to make their own investment pay off.

In business, competition is never as healthy as total domination

It’s better to choose an excellent company in a stagnant industry than a good company in a growing industry. In a stagnant industry, the weak go under and the survivors increase their market share with hardly any borrowing.

Invest in the company with the fewest colour photos in its annual report (ceteris paribus)

Lynch tells the story of Crown Cork & Seal, which had an old-fashioned chief executive. John Connelly had an aversion to extravagance. His annual reports showed that the company’s ratio of expenses to sales was only 2.5%, well below the industry average of 15%. Its annual reports didn’t contain a single photograph. He didn’t spend money on that. Where he did spend money was on new can-making technology that allowed the company to keep its status as the lowest-cost producer. Whatever he didn’t spend on manufacturing technology, he spent on buying back shares. Connelly worked for his shareholders.

Unless you’re a short seller or a poet looking for a rich wife, pessimism never pays

When there’s a recession, you have to think positively. However discouraging the news in the papers, we should know that the economy will recover. That’s why investing in cyclical companies when they are at their lowest point is usually very profitable for the investor who doesn’t get carried away by pessimism. A depressed cyclical company with a solid balance sheet is bound to rise again.

Whatever the Queen is selling, buy it

By this, Lynch is referring to privatisations. Privatising is, after all, taking something that belongs to citizens and selling it back to them. Every time the US or British government has privatised a company and put its shares up for sale, it has turned out to be an excellent deal for investors.

Peter Lynch’s 25 golden rules

1. Investing can be fun, exciting and dangerous if you don’t do your homework.
2. Your edge as an investor isn’t something you get from the experts on Wall Street. It’s something you already have. You can outperform the experts if you use your own knowledge to invest in companies you already understand.
3. Over the last 30 years, the stock market has been dominated by a pack of professional investors. This makes things easier for the amateur investor. You can beat the market by ignoring the herd.
4. Behind every stock there is a company. Find out what it’s doing.
5. Often there is no correlation between how well a company’s business is doing and how well its shares perform on the stock market for a few months, or even for years. In the long run, there is a 100% correlation between the company’s success and the performance of its shares. This disparity is the key to making money. Being patient and buying good companies pays off.
6. You should know what you own and why you own it. “This company is dirt cheap” isn’t good enough for me.
7. Risky bets, like long-range shots, almost always miss the target.
8. Buying stocks is like having children. Don’t have more than you can take care of.
9. If you can’t find companies that look attractive to buy, leave the money in the bank until you find some.
10. Never invest in a company whose finances you don’t understand. The biggest losses come from companies with poor balance sheets. Before you risk your money investing in a company, study its balance sheet.
11. Avoid hot companies in hot industries. Good companies in industries that are neither fashionable nor growing are consistent winners.
12. With small companies, it’s better to wait until they are profitable before investing.
13. If you’re thinking about investing in a troubled industry, buy companies with staying power. Also wait for the industry to show signs of recovery. Buggy whips and radio tubes were troubled industries that never recovered.
14. If you invest 1,000 dollars in a stock, all you can lose is 1,000 dollars, but if you’re patient, over time you could make 10,000 or even 50,000 dollars. An amateur investor can focus on a few good companies, while a fund manager is obliged to diversify. If you hold too many companies, you lose the advantage of concentration.
15. In every industry and every region of the country, the amateur observer can find fast-growing companies long before professional investors do.
16. A stock market decline is a great opportunity to buy the bargains sold by investors fleeing the storm in a panic.
17. Everyone has the brainpower to make money in the stock market, but not everyone has the stomach for it. If you’re likely to sell everything in the middle of a panic, you should stay away from stocks and mutual funds altogether.
18. There’s always something to worry about in the stock market. Sell your shares because the company’s fundamentals have deteriorated, not because everyone else has panicked.
19. Nobody can predict interest rates, the direction of the economy or the stock market. Ignore all these forecasts and concentrate only on what is happening with each company you’ve invested in.
20. If you study 10 companies, you’ll find one whose track record is better than expected. If you study 50, you’ll find five. There are always pleasant surprises in the market: companies whose merits have gone unnoticed by Wall Street.
21. If you don’t study any companies, you’ll have the same luck investing as you would playing poker without looking at your cards.
22. Time is on your side if you own shares in superior companies. You can afford to be patient: even if you missed the first five years of Wal-Mart, it was a great company to buy and hold for the next five years.
23. If you have the stomach for the stock market but not the time or the inclination, invest in mutual funds, but diversify among them: funds that invest in growth companies, value companies, small companies, large companies and so on.
24. Among the world’s stock markets, the US market isn’t at the top, so it’s not a bad idea to diversify into other, emerging markets.
25. In the long run, a portfolio of well-chosen stocks or mutual funds will always outperform a portfolio of bonds. In the long run, a portfolio of poorly chosen stocks will do no better than money left under the mattress.

See also: 7 stock market investing questions people ask us

Featured image: Grk1011, CC BY-SA 3.0, via Wikimedia Commons.