Peter Lynch On Playing The Market
Even though the reality of investing is often extremely disappointing or worse, the literature in the field can be outstanding. There is no shortage of excellent books, or of journalistic and academic writing. In this article, we'll take a look at Peter Lynch's "One Up on Wall Street" and get an overview of the kind of timeless advice that he provides. (For more, see Pick Stocks Like Peter Lynch.)
Tutorial: Stock Picking Strategies
Market Timing and Daring to be Different
Lynch sums up issues on market timing beautifully. His basic idea is that, not only is it difficult to predict the markets, but small investors can be both pessimistic and optimistic at all the wrong times. Basically, it can be self-defeating to try to invest in good markets and get out of bad ones. That's not to imply that the small investor doesn't know what they're doing, but rather that accurate market timing, especially in the short run, is unlikely. The critical point is that you don't have to be able to predict the stock market to make money with it.
Some of the best and most successful professional traders have an uncanny ability to sniff out really good stocks, before they become trendy and overpriced. According to Lynch, this is because the risks of the stock market can be reduced by "proper play," just like the risks of stud poker.
Overheated Markets
What Lynch makes clear is that there are bad times to buy. This is not market timing, it is simply true that sometimes the market is dangerously high and at other times, way too low; for buyers, this can be appealingly low. Although, according to him, there is no absolute division between safe and rash places to invest, experts, or just ordinary, sensible people who take the trouble to find out, can find reliable signs of where they should be investing. When people are getting greedy, excessively risk-friendly, and are taking too many chances, the market should be avoided, or exposure to it at least reduced. (To learn more, see our Market Crashes Tutorial.)
Nothing, says Lynch, is more dangerous than extremely overpriced stocks, and it is possible to know when this is the case. There is nothing intrinsically wrong with the stocks of good companies; what is wrong is the way people invest. This can apply just as much to so-called professionals, as to the investor on the street. Likewise, for people who just do not have the time horizon for stocks, even buying blue chips would be too risky. Lynch stresses that it is important to remember that the market, like individual stocks, can move in the opposite direction of the fundamentals. If stocks, or more likely, too much of your money in them, are unsuitable for your needs and appetite for risk, don't even think about it. Diversification is the essence of sensible investing. (To learn more, see The Importance Of Diversification.)
What Most Brokers Really Do and Don't
If you are a small investor, don't expect too much attention from the industry. Lynch warns that there's an unwritten rule in the industry that, the bigger the client, the more talking the portfolio manager has to do to please him. If you are a small fish, he may not bother much at all, just leaving the money at the mercy of the market.
It's an ugly reality that most brokers just do not have the guts to buy into unknown companies. Believe it or not, the average Wall Street professional isn't looking for reasons to buy exciting stocks, and when these companies rocket up, the broker will have all manner of excuses for not having bought.
How to Do It
Lynch explains that the next investment is never like the last one and yet we can't help readying ourselves for it anyway. The economy and markets evolve in a mixture of the unpredictable and the predictable. We cannot know how the future will unfold, but we can still invest prudently and make money. The significance of this simple fact cannot be overemphasized. The trick is to buy great companies, especially those that are undervalued and/or underappreciated. Alternatively, if you pick the right stock the market will take care of itself.
There are some common characteristics of companies that should be avoided like the plague. By using such methods as cash, debt, price to earnings ratios, profit margins, book value and dividends, you can get a pretty good idea about whether a company is worth buying into.
It's also a good idea to keep checking; after all, sooner or later every popular, fast-growing industry becomes a slow-growing industry. There is a tendency to think things will never change, and while you may always want to keep some stalwarts in your portfolio, these, too, need to be monitored. (For more, see Fundamental Analysis For Traders.)
Other Classic Blunders and Seriously Dangerous Delusions
Apart from all the above, Lynch teaches that there are many disastrous things that many people think, and do, again and again, but which can easily be avoided. You don't need to time the market to believe that if it's gone down so much already, it can't get much lower. By the same token, people who think they can always tell when a stock has hit the bottom, are themselves going to get hit.
In the same vein, do not believe that stocks always come back or that conservative stocks don't fluctuate much. Similarly, believing that when the stock goes up you're right, or when it's down, you're wrong, can cost you a lot of money.
The Bottom Line
Lynch summarizes his book with some succinct advice: It is inevitable that there will be sharp declines in the market that present buying opportunities. To come out ahead, you don't have to be right all the time. Nevertheless, trying to predict the market in the short term is impossible. Companies don't grow without good reason and fast growers won't stay that way forever. If you don't think you can beat the market, for whatever reason, buy a mutual fund and save both the work and the money; don't count on the industry to do a great job, on your behalf.
