Peter Lynch: The 5 Secrets to Outperforming the Market
So if you've been following this channel for any period of time, you know I'm a big fan of Warren Buffett. Just look at all of the videos I've made on him and his investing principles. However, what might come as a big surprise to you is that it actually wasn't Warren Buffett that first got me interested in investing; it was actually Peter Lynch. In fact, I credit studying Peter Lynch's investing principles as one of the biggest factors that helped me land a job as an investment analyst right out of college.
Whether you're just starting out on your investing journey or have been investing for decades, Peter Lynch is absolutely an investor you should be studying. In fact, I would make the argument that Lynch is the single best stock picker of all time. If you want to find stocks that Peter Lynch refers to as "10 Baggers" or stocks that go up 10 times in value when you hold them, make sure to watch the end of this video.
I've read every book Lynch has written: "One Up on Wall Street," "Beating the Street," and "Learn to Earn." Together, these books are well over 1,000 pages of pure investing wisdom. Additionally, I've listened to every interview and lecture Lynch has given. I'm going to take all of the knowledge I've learned from my hours of research and condense it into this one video, focusing on the key takeaways you need to know to make you a better investor. All I ask in exchange is for you to like this video and subscribe to the channel because it's my goal to make you a better investor by studying the world's greatest investors.
Now, let's get into the video. For those of you that may not be familiar, Peter Lynch is one of the most successful investors of all time. Lynch managed the legendary Magellan Fund at Fidelity. The fund earned an annualized return of 29.2% during his time running it, more than double what the S&P 500 earned during that time.
Now, let's get into the five lessons and principles from Peter Lynch that you can start applying to your own investing today. The first lesson from studying Peter Lynch is the concept of "Know What You Own." This is one of the single biggest pieces of advice from Peter Lynch that investors need to take to heart.
When you first hear this principle of "Know What You Own," you may be saying, "Duh, that's so obvious." However, you may be surprised to learn that a lot of investors don't really have a clue about what they own and why they own it when they buy a certain stock. Lynch says that if you were to really press someone on why they bought a particular stock, their answer would likely be, "Because this sucker is going up!"
Peter Lynch likes to talk about how when someone is looking to buy a new appliance for their kitchen, they will do a ton of research. They'll go online and learn about that appliance. They will read hundreds of reviews from customers, and they will go to multiple stores and compare prices to make sure they're getting the most value for their money.
However, Lynch also talks about how that same person will hear someone talk about a stock on the bus or around the subway and then go out and put a significant amount of their net worth into that stock on the same day, all without doing any of their own research. Peter Lynch told that story during the 1990s, but it still applies today. The only change I would make is instead of hearing that tip on the subway, they hear it here on YouTube.
It's interesting how people's behaviors towards the stock market don't really change in this regard. People in the 1920s used to get stock tips from the shoeshine boy; then in the 1970s and 1980s, it was magazines; then in the early 2000s and 2010s, it was the internet. Now, in 2022, one of the biggest places people go for stock tips is right here on YouTube.
Now I'm not saying you should completely ignore these tips; instead, maybe use them as a starting point to begin your own research process. It's important to do your own research to truly know what you own and why you own it. So what exactly does it mean to quote "Know What You Own"?
Peter Lynch says you should have a deep enough understanding of the stock and why you own it to be able to explain it to a 10-year-old in 2 minutes or less. If you can explain why you bought the stock to a 10-year-old in 2 minutes or less, you simply shouldn't own that stock. This leads us to the next piece of advice from Peter Lynch: this advice is extremely relevant in today's market—avoid owning what I refer to as "fad stocks."
Fad stocks are stocks that are super popular in the eyes of investors for reasons that are likely unjustified, and this popularity usually has to do with growth projections years into the future. There's usually a lot of hype and excitement around the stocks and the industry. All of this excitement results in high stock prices that, over time, will turn out to be unsustainable.
An interesting thing I learned from Peter Lynch is how you usually want to avoid areas of the stock market that are getting a ton of attention. The reason being that it's hard to find any undervalued stocks if investors are super excited about a particular area of the stock market.
A very recent example of an investing fad was SPACs. It seemed like there was a period of time in the back half of 2020 and the first part of 2021 when SPACs were some of the hottest stocks. It seemed like all SPAC stocks were shooting up in value regardless of whether or not the underlying business was actually good.
Take a look at the index that measures the return of SPACs. In October 2020, the index was around 500. Just a few months later, in February 2021, the index was at nearly 1,000. This means that the value of SPAC stocks had nearly doubled in just four short months. There is no way that the underlying value of these businesses had doubled in that same period of time. This is an example of a fad stock. These stocks became super popular, and their stock prices shot up as a result.
Just like fads when it comes to clothing, what is cool now won't necessarily be cool forever. Look at what happened to the value of the index once investors started to lose interest in SPACs. SPACs consistently declined in price, and people that invested in the peak of the fad lost a ton of money. The SPAC index has been cut in half since its peak in February 2021. There will always be new fads when it comes to investing. Peter Lynch has invested through countless throughout history. He says it's virtually impossible to make money investing in them. Instead, he says it's better to invest in the opposite of fad stocks—boring stocks.
Some of his best investments were made in companies considered boring to the stock market at the time. One of Lynch's great investments of all time was the coffee shop chain Dunkin' Donuts. While a company like Dunkin' Donuts will likely never be a hot stock for investors, that doesn't mean it can't make you rich. This "boring" stock made Peter Lynch and his investors tens of millions of dollars as the stock went up by more than 10 times from when he bought it. In investing, it's much better to make money than to be cool and invest in fad stocks.
The next piece of advice from Peter Lynch is truly a gem. It definitely goes against conventional investing wisdom, but hey, you can't generate 30% annual returns like Lynch by following conventional wisdom. This piece of advice is: Don't try to predict the economy. Lynch has a quote that all investors need to take to heart: "If you spend 13 minutes a year on economics, you wasted 10 minutes."
That's definitely an attention-grabbing statement and one of my personal favorite quotes in all of investing. He went on to clarify what he meant. It's futile to predict the economy, interest rates, and the stock market. I would love to know when we are going to have a recession. I would love to know if interest rates were going up or down. I would love to know when the stock market is going up—that would be helpful. I would like to get next year's Wall Street Journal. Unfortunately, you don't get it.
This quote makes a ton of sense and seems extremely logical; however, this is the complete opposite of how virtually every investor operates. They try to predict what's going to happen to the economy and then jump in and out of stocks based on that view of the economy. One of the biggest things I've learned from studying Lynch is the importance of ignoring macroeconomics and instead focusing on microeconomics.
Macroeconomics are things like whether the economy is going to grow this year and by how much, what inflation is going to do, and where interest rates are going to go. Lynch makes the argument that these things would certainly be useful to know, but at the end of the day, they are unknowable. Instead, focus on the microeconomic facts of the company. Take Coca-Cola, for example. What you should be looking at is whether Coca-Cola is taking market share, whether the brand has pricing power, and what the company is doing with all the cash it generates. These are the things you as an investor should be spending your time thinking about.
Next up on our list of lessons from Peter Lynch is the concept of avoiding what he refers to as "diversification." This term "diversification" was coined in his famous book "One Up on Wall Street." You can actually check out a summary video I made on the book here. Conventional investing wisdom states that investors should have a diversified portfolio, and this is defined as having a variety of stocks and a variety of industries. Many investors that take this conventional approach think that investors should have a portfolio that consists of stocks from each of the different sectors of the economy.
Additionally, no matter how much an investor likes a certain stock, it shouldn't make up more than just a few percentage points of their overall portfolio. I don't know if you're picking up on a theme here, but Peter Lynch is not one for conventional investing wisdom. One of the core elements of Peter Lynch's strategy is avoiding the so-called "deification."
Let's say we have an investor named Jon. Jon has a portfolio of 10 to 15 stocks, and because Jon watches a ton of investor-centered videos, he knows Peter Lynch's investing principles and used them to select these stocks. Which, as a side note, should serve as a reminder to subscribe to the channel if you aren't already because I know you want to become a better investor. But anyway, I digress. Back to Jon.
Jon may feel pressure from conventional investing wisdom to add "quote" exposure to his portfolio. Maybe Jon doesn't own any energy or software stocks, and his portfolio doesn't have any bonds or gold. Portfolio diversification theory would state that Jon needs to add these to his portfolio. However, what if Jon can't find any attractive investments in these areas?
Jon deciding to add these investments just for portfolio diversification's sake would be an example of diversification at work. If 20 to 30% of Jon's investments are in unattractive stocks just because he followed conventional theory, how could he expect to generate strong investment results? This ties into lesson number five on our list, which is a two-parter: hold for the long term and focus on 10 Baggers.
The reason why conventional wisdom advocates for diversification is because it makes for a less volatile portfolio, meaning your portfolio won't go up or down as much over any short period of time. However, Peter Lynch has extensively talked about how in order to outperform the market, you as an investor must be focused on the long term.
Peter Lynch has even gone as far as to say that it is impossible to predict what a stock is going to do over the next 3 months or even a year. He said this in the 1990s, and it seems like people's time horizons have gotten even shorter. Just look here on YouTube as an example. There are people who claim to know what a stock is going to do over the next month, week, or even, in some cases, the very next day.
However, Lynch is adamant that this is no way to actually outperform the market. The reason for this is because the stock's price eventually follows its growth and earnings over time. However, in the meantime, the stock price can fluctuate greatly. This means that if you are able to invest in a company that will double its earnings over the next 5 years, that means that a stock price should double over that same period since the company is now making double in earnings.
This logic makes a ton of sense; however, in between now and then, the stock price will move around dramatically for a variety of reasons. All of these reasons are completely random and unpredictable. Instead, Lynch talks about how it's much better to focus on something much more predictable—the company's ability to grow its earnings over time because the stock price will eventually follow suit.
This leads us to the second part of this lesson: focus on what Peter Lynch refers to as "10 Baggers." 10 Baggers are an investor's dream—stocks that increase by a factor of 10 over the time you hold them. In order to have a 10 Bagger in your portfolio, you have to avoid one big mistake that is common for investors: selling a stock too early.
This is where having a long-term investing horizon directly relates to finding 10 Baggers in your portfolio. Many investors will buy a stock and see the price go up 10, 20, or even 30%. They will be satisfied with that gain and sell their stock, only to watch the stock price double, triple, and eventually rise 10 times from the price that they originally bought it at. Most investors make the mistake of doing all the hard work of identifying a great stock but don't have the patience and conviction to let it grow over time.
This is where one of my all-time favorite Peter Lynch quotes comes into play: "Selling your winners and buying your losers is like watering your weeds and cutting your flowers." This quote is so good that the investing king himself, Warren Buffett, actually called Peter Lynch one night to ask him for permission to include it in his legendary Berkshire Hathaway annual report.
What Lynch is saying here is that it is a mistake to sell a stock just because the price has increased. If the stock still has significant room to grow, it's far better to keep that great company in your portfolio.
So there we have it. Remember these five lessons from Peter Lynch:
Know what you own. If you don't know what you own, odds are you will panic-sell the first time the stock price falls. Investing in businesses you don't understand is asking for trouble.
Avoid fad stocks. It's hard to make a lot of money buying the same hot stocks as other people. Always be skeptical of stocks that are promising large amounts of growth well into the future and are trading at prices that incorporate some very optimistic projections. Instead, some of the best investments come from stocks that aren't getting a ton of attention.
Don't try to predict the economy. I would bet that economists are some of the highest IQ people in the world. Even so, that doesn't mean collectively they're good at accurately predicting the economy. Understand that the economy is impossible to predict with a high degree of certainty. Remember, instead of focusing on macroeconomics, focus on microeconomics of companies.
Avoid diversification. When you think about it, it doesn't make a ton of sense to buy stocks you don't understand for the sake of having a diversified portfolio. It's hard to outperform the market following conventional wisdom.
Hold for the long term and focus on 10 Baggers. The best performing investors of all time—Peter Lynch, Warren Buffett, Charlie Munger— all say that predicting stock prices is impossible in the short term. These guys are all extremely brilliant and have insanely high IQs. If they admit that they can't predict the movement of stock prices in the short term, why should anyone else actually think they can?
Make sure to comment below which of these lessons from Peter Lynch you found the most helpful, and if you haven't already, make sure to like this video and subscribe to the Investor Center because it's my goal to make you a better investor by studying the world's greatest investors.
Thanks for watching, and looking forward to talking to you again next time.