Peter Lynch: How to Invest Small Amounts of Money

I think the public can do extremely well in the stock market on their own. I think the fact that institutions dominate the market today is a positive for small investors. These institutions push stocks on usual lows; they push them on usual highs. For someone that can sit back and have their own opinion, know something about the industry, this is a positive.

I'm going to let you in on a secret during this video: everyone is getting it completely wrong when it comes to investing. Conventional investing wisdom states that the average person doesn't stand a chance against the ones on Wall Street. However, believe it or not, the individual investor has a massive advantage over professional investors. But please don't take my word for it; this is coming from legendary investor Peter Lynch.

Make sure to stick around till the end of this video because we are going to cover the four most important pieces of advice from Lynch on how he recommends people invest small sums of money. Now, let's get into it. I frankly think it's a tragedy in America that the small investor has been convinced by the media—the print media, the radio, the television media—that they don't have a chance; that they don't. The big institutions, with all their computers and all their degrees and all their money, have all the edges, and it just isn't true at all.

When they’re convinced, when this happens, when this occurs, people act accordingly. When they believe it, they buy stocks for a week, and they buy options, and they buy the Chile fund this week, and next week it's the Argentina fund. They get results proportionate to that kind of investing, and that's very bothersome.

I think the public can do extremely well in the stock market on their own. I think the fact that institutions dominate the market today is a positive for small investors. These institutions push stocks on usual lows; they push them on usual highs. For someone that can sit back and have their own opinion, know something about the industry, this is a positive; it's not a negative. So that's what I want to talk about.

The single, single most important thing to me in the stock market for anyone is to know what you own. I'm amazed how many people own stocks they would not be able to tell you why they own it. They couldn't say in a minute or less why they own it. Actually, if you really press them down, they'd say the reason I own this is the sucker going up; that’s the only reason. That's the only reason they own it. And if you can't explain—I’m serious—you can’t explain to a 10-year-old in two minutes or less why you own a stock, you shouldn't own it. And that's true. I think about 80% of people that own stocks.

If you're an institutional investor and want to invest successfully, Peter Lynch has laid out four things you need to do. According to Lynch, the cardinal rule of investing is know what you own and why you own it. This means that if you own a stock, you should have a deep understanding of the company, its products, and what separates the business from competition. Additionally, you should be able to explain to a kid why you own the stock.

I remember the first time I ever heard this advice from Lynch; I was a college student and had just finished his must-read book "One Up on Wall Street." In this book, Peter Lynch talked about how even professional investors often buy stocks without really understanding the business or being able to explain why it makes sense to own it. At first, I thought there was absolutely no way this could be true; professional investors are some of the most intelligent, well-educated people on the planet.

I believed professional investors could never do something so foolish. Well, then I joined the industry myself as one of those professional investors and saw for myself just how true Lynch's words were. For background, professional investors have their investment performance evaluated relative to an index, often the S&P 500. The S&P 500 Index consists of the roughly 500 largest companies in the U.S. economy.

The index is weighted based on the market cap of each company, with the larger market cap companies accounting for a larger percentage of the index. This means that the larger a company is, the more its stock performance drives returns for the entire index. Let's use Nvidia as an example. Nvidia has a market cap of $1 trillion and accounts for roughly 3% of the entire S&P 500 Index. While that may not sound like a lot, one company making up 3% of the value of an index with 500 companies is truly massive.

Nvidia stock has been on a tear recently, up 200% over the past year, as of the making of this video. Nvidia is a technology company known for designing and manufacturing graphics processing units. The average portfolio manager on Wall Street is likely in their 40s or 50s with a finance background. Put another way, they aren't geniuses when it comes to cutting-edge technology.

If a professional fund manager followed Peter Lynch's advice of only investing in companies they understand, there is a good chance they wouldn't have owned Nvidia stock. Investors in this professional fund would likely be upset at him for missing out on Nvidia. Professional investors are human; they have a mortgage payment every month and bills to pay. They want to keep their job, and to do that, they have to keep their investors happy, which often results in professional investors owning stocks they don't understand and owning them for no reason other than to make themselves look better to current and potential investors in their fund.

Thankfully, individual investors don't have this problem. The only investor they have to answer to is themselves. Simply following Lynch's rule of know what you own and why you own it will put you ahead of most Wall Street investors.

The second tip from Peter Lynch on how to invest small amounts of money is to focus on smaller companies. During his time running the legendary Fidelity Magellan Fund, Lynch was able to generate an average annual return of nearly 30%. A big driver of these impressive returns was his ability to identify what he calls "10 baggers." 10 Baggers are stocks that 10x in value, and according to Lynch, these are the Holy Grail when it comes to investing.

In fact, Lynch even went as far as to write, "The very best way to make money in the stock market is in a small growth company that has been profitable for a couple of years and simply goes on growing." The reason Lynch focuses on smaller companies is that on average they tend to have more growth potential than large, well-known stocks. This makes a ton of sense when you think about it; it is easier for a company to go from a $1 billion market cap to $10 billion than it is for a company to go from a $100 billion market cap to $1 trillion. Going from $1 billion to $10 billion means growing the market cap by $9 billion; meanwhile, going from $100 billion to $1 trillion means adding an additional $900 billion in market cap.

Once you understand this concept, it makes sense why Peter Lynch focuses on smaller companies. When Peter Lynch was investing, finding companies that met his criteria took weeks and weeks of going through thousands of pages of financial documents. Thankfully for us, we have the internet and online brokerages like Mumu. We can easily find companies that meet Lynch's criteria by jumping to a stock screener like this one here on Mumu. The process is incredibly simple. We're going to put the market cap range between $100 million and $1 billion.

Let's also say that the company has had to be profitable over the last year. We will make the net profit greater than zero to narrow our list down even further. We will also add a PE ratio range of 1 to 15. These three filters leave us with a good starting point to look for potential opportunities. These powerful and easy-to-use screeners are just one of the reasons I like Mumu's sophisticated investment platform.

Thankfully, Mumu was kind enough to sponsor this video and give my viewers an exclusive massive signup bonus. By using my referral link in the description of this video, new users will receive up to 15 free stocks when they make a qualified deposit into their account. No matter where you are in your investment journey, every dollar matters. The fact that Mumu offers a 5.1% APY on all your uninvested cash and is also giving my audience such a generous sign-up bonus is huge. Make sure to sign up using my link because these free stocks will help you get started.

Now back to the list. Number three on Peter Lynch's list is to take a long-term approach. In the clip from earlier in the video, Lynch talked about how the fact that professional investors manage so much money is actually a good thing for individual investors. At first, this may not make a ton of sense, but let me explain.

One of my favorite analogies to demonstrate how stock prices move is the stadium analogy. Imagine the stadium of your favorite sports team. There is a fixed number of seats in that stadium. When the team is doing really well and there is a big game, ticket prices for each seat are expensive. Everyone understands why; there are only a certain number of seats and a lot of people want to attend the game; therefore, prices go up. The opposite is also true; if nobody wants to go to that particular game, the stadium might practically give away the tickets for free.

Since there are a fixed number of seats in the stadium, the price for a ticket depends on how high demand is to sit in one of those seats. That same basic logic applies to a stock. With each stock, there are only a certain number of shares outstanding in that company. Just like ticket prices for a seat in our hypothetical stadium, stock prices fluctuate based on the current demand to own shares.

Collectively, large institutional investors manage tens of trillions of dollars. This can make for some wild swings in stock prices. When institutional investors collectively decide to sell their hypothetical stadium tickets and rush for the exits, the majority of institutional investors are overly focused on short-term performance. This dynamic can create big opportunities for the individual investor.

Let's use Meta stock as an example, parent company of Facebook. Meta stock peaked at a high of over $375 in September 2021. However, the business hit some speed bumps; performance suffered as the business faced increased competition, and the founder was spending heavily to build out new businesses. Formerly a darling of Wall Street, large money managers flooded to exit the hypothetical stadium. Shares fell by over 75% over the next year or so as professional investors were worried about the short-term performance of the business.

This was the perfect opportunity for the individual investor who could focus on the long-term and ignore the short-term headwinds. At the bottom, Meta stock had a market cap of just $250 billion. Meanwhile, the company generated $39 billion in cash flow in 2021. That is not sales, that's not even profit; that is $39 billion in hard cold cash added to its bank account. You didn't have to be a genius to see why the stock was a good investment at its low; you just had to be willing to look long-term and ignore the short-term noise.

This example is, of course, just one, but it demonstrates how large investors can cause some pretty wild fluctuations in stock prices. This leads perfectly into number four on the list: be okay with stock price declines. Most people assume that in order to be a successful investor, you need to be a genius. This commonly held belief is seemingly supported by the fact that many of Wall Street's top investment firms are filled with graduates from some of the world's most elite educational institutions.

While society and the media say only geniuses can be good investors, Peter Lynch strongly disagrees. In fact, Lynch says the most important organ when it comes to investing isn't your brain; it's actually your stomach. Here's what that means: take a look at the stock chart for Coca-Cola. Coca-Cola is considered one of the world's "quote unquote" safest companies. The company has been around for 100 years and will probably be around for 100 more.

Despite this fact, and just like any other stock, Coca-Cola's stock price has still had wild swings. In the investing industry, they use the fancy word "volatility" to describe these price movements. Volatility feels great when the stock price rises dramatically; however, volatility when it results in a falling stock price feels extremely painful for most investors. In fact, it's human nature to want to sell a stock once its price has declined. Countless psychological studies have shown that the pain of losing money is far greater than the joy that comes from making it.

Lynch says that successful investors are the ones that have the stomach to hold on and not sell when their brain is telling them to. This is yet another area where the individual investor has an advantage over the pro. We talked earlier about how there is nothing worse for the average professional fund manager than being incorrect in the eyes of investors that give them money to manage. You can't blame the professionals either; their entire career is based on their ability to keep investors happy. One way fund managers keep investors happy is by limiting how much their portfolio declines.

In the world of hedge funds, this has given rise to a practice known as a drawdown limit. Many of today's largest hedge funds operate as what are called multi-manager hedge funds. This means that instead of one single manager managing all the money, the money is spread out among many different portfolio managers in order to "quote unquote" manage risk. Each of these portfolio managers has what is called a drawdown limit. In simple terms, this is the max amount their portfolio can fall until they are pretty much forced to sell all their holdings.

To add insult to injury, if a portfolio manager hits the drawdown limit, they're also likely fired. Naturally, this dynamic makes portfolio managers at these firms extremely cautious. As a result, even if they think a stock is cheap, they likely won't invest if there is potential for the stock to decline even further.

The individual investor doesn't have to operate under the constraint of a drawdown limit. If they like a stock and think it's cheap, they can buy it. If a stock falls further and they still like it, they can buy even more. Use Warren Buffett and his purchase of Apple stock as an example. When Buffett first bought Apple stock, it had just fallen over 25% from its recent highs. There was very much a possibility that the stock could continue to decline. Buffett didn't care; he bought Apple stock with the mindset that if the stock price fell further, he would just buy more.

To say this investment worked out well would be quite the understatement. Buffett's stake in Apple is worth over $150 billion as of the making of this video, and it will likely go down in history as Buffett's most profitable investment. However, if Buffett was worried about Apple stock declining, he would have missed the opportunity. This is precisely why Lynch says that a strong stomach is more important than a genius brain when it comes to investing. Plenty of people were smart enough to understand that Apple stock was a good buy when Buffett first started buying; however, not everyone had a strong enough stomach to be comfortable with the fact that the stock had just declined 25% from its recent highs.

There is very much the possibility that the stock could have fallen further. As an individual investor in small sums of money, you have advantages over the pros on Wall Street. Make sure you use them. So there we have it. Make sure to subscribe to the channel because it's my goal to make you a better investor by studying the world's greatest investors. Talk to you again soon.