The Advantages of Amateur Investors

Peter Lynch, a legendary investor, provides insight into how success in the investing world does not necessarily require one to chase after fleeting trendsDuring the fervent rise of the internet bubble, Lynch remained rooted in traditional investment principlesHis stock selection was based on timeless fundamentals: a successful company expanding into new markets sees profits grow, thereby pushing stock prices upwardSimilarly, a previously struggling company that begins to improve will also see its stock price rallyUltimately, corporate earnings dictate the success or failure of any investmentFocusing too intently on the stock market's performance over a day, week, or even a month only serves as a distraction for investors

Interestingly, the internet is hardly the first revolutionary innovation to reshape the world

Prior inventions like the railroad, telephone, automobile, airplane, and television profoundly altered the lives of many, particularly among the wealthyEach of these industries birthed numerous new businesses, yet only a handful emerged victorious to dominate their respective fieldsThe concept of "survival of the fittest" rings true, as shareholders in successful companies typically reap significant profits, while investors in obsolete or underperforming firms suffer lossesEven highly regarded companies can pose substantial risks if purchased at exorbitant pricesTo avoid catastrophic investments in companies with dubious futures, Lynch outlined three strategic approaches in the vestige of the internet boom.

The first strategy Lynch labeled the “Pick and Shovel” investment strategyHistorically, during gold rushes, many aspiring prospectors failed to strike it rich, while those who supplied them, selling picks, shovels, and provisions, often made fortunes

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Therefore, Lynch advocated investing in non-internet companies that benefit from internet transactionsA prime example is delivery services, which grew significantly in tandem with the rise of e-commerce, along with manufacturers of essential infrastructure like networking equipment.

The second approach suggested investors buy into companies whose internet ventures come at virtually no costThis refers to companies with real operating revenues and reasonable stock prices whose internet functionalities are merely an extension of their existing businessesInvestors essentially pay for the non-internet business while reaping the benefits of the embedded internet component without paying extra for it.

Lynch’s third strategy focuses on investing in traditional “brick-and-mortar” companies that stand to benefit from internet efficiencies

Many longstanding businesses have considerably cut costs and streamlined operations through the internet, resulting in impressive increases in profitabilityFor instance, supermarkets adopted scanner technology years ago, drastically reducing theft and offering better inventory control.

As predicted by Lynch, the future will bring forth great success stories driven by the internet and its supporting industriesWhen wishes transform into reality, the ultimate winners become all the more apparentWise investors would do well to wait until a company’s potential is indisputable before investing.

Microsoft exemplifies a case of legendary business successDespite this, Lynch admitted missing out on the opportunity to invest in itHe recounts that from virtually its inception, the stocks of tech giants like Microsoft, Cisco, and Intel showed explosive growth

Microsoft’s shares were initially priced at a mere 15 cents in 1986 and remained under a dollar for several yearsAfter its strategic launch of Windows 95, if an investor had waited to invest until witnessing its success, they would still have seen a remarkable sevenfold increase in their investmentObservers quickly recognized that virtually every computer utilized Windows software, save for the rare Apple machine.

Using Microsoft as an illustration, Lynch highlights an essential theme: whether in workplaces, shopping centers, or elsewhere, amateur investors can uncover potential high-growth companies by closely monitoring their developmentsLynch steadfastly believed that average amateur investors could have a superior edge over professional fund managers in the investing realm.

However, Lynch warned against the idea of investing solely because of personal affinity

Liking a store or a specific product can provide sufficient interest to consider including a company in an investment portfolio, but it is not in itself a valid basis for purchasing its stockAn informed decision regarding a company’s profit outlook, financial standing, competitive position, and development strategy is crucial before undertaking the risk of an investment.

The Principle of "Tail-end Victory"

After departing from the Magellan Fund, Lynch maintained a watch on around 50 companiesHis portfolio included shares of savings and loan associations as well as several high-growth stocks he had held since the 1980sOther investments dated back to the 1970s and remained robustAdditionally, he retained stocks with poor performance, believing their solid financial condition signified that better days were ahead.

He offered the significant insight that not every stock in a portfolio needs to yield a profit

In his experience, generating returns from 6 out of 10 stocks stands as a satisfactory outcomeThus, finding just a few high-performance stocks can bring about lifelong investment success as their profits substantially outweigh losses from underperforming investmentsThis philosophy has come to be recognized as “tail-end victory.”

The stories of Bethlehem Steel and General Electric provide valuable lessonsOnce a prominent symbol of global influence, Bethlehem Steel's disappointing performance haunted investorsIts price plummeted from $60 a share in 1958 to $17 by 1989, causing enormous losses for both loyal shareholders and speculative investorsThe reality that a low-priced stock can decline even further is evident in its staggering fall below $5 per share.

Conversely, Lynch underestimated General Electric as unable to grow profits quickly due to its sheer size

Ironically, this company managed to exceed Lynch’s expectations for share price appreciation by providing quality products that greatly improved life qualityUnder the decisive leadership of Jack Welch, GE navigated into a period of rapid profit growth in the 1990s, underscoring the importance of persistent observation of a company's progress.

Overall, Lynch maintains that the fundamental principles of stock investing are simple and timelessStocks are not lotteries; they are reflections of real companies that can sometimes perform better or worseIf a company's performance deteriorates compared to past results, its stock price typically falls; conversely, if a company performs better, the stock price tends to riseInvesting in a company with a trajectory of growing profits tends to yield substantial returnsSince World War II, American public companies have seen their earnings grow by 55 times while the market surged by 60 times

This growth persisted despite four wars, nine recessions, four different presidents, including one who was impeached.

In the 1990s, many of the top-performing stocks in the U.Sstock market belonged to high-tech firmsDell, in particular, achieved astronomical levels of success, setting sales records and garnering consumer loyalty, delivering a shocking return of 889 times for early investorsA mere $10,000 investment in Dell shares would have ballooned to approximately $8.9 million.

In those ten years, many successful stocks also stemmed from traditional retail, highlighting that well-managed companies have great potential for high returns based on consumer experiencesEven two smaller banks appeared among the top 100 stocks, reminding investors that potential groundbreaking companies can emerge from any industry, including sectors perceived as stagnant or slow-growing.

Adhering to Successful Investment Strategies

Lynch emphasized that maintaining a sound investment strategy is crucial, regardless of whether returns are booming or stagnant

While annual investment returns may sometimes soar to 30%, they could also drop to a mere 2% or even record losses of 20%. Such fluctuations convey the inherent unpredictability of investing—something one must accept.

Realistic investment return targets of 25% to 30% are impractical; more achievable returns should exceed fixed-income investments such as bondsLong-term stock yield expectations should generally hover between 9%-10%, reflecting historical averages of stock indexes.

If amateur investors choose to research and select stocks themselves, they must validate that the time and effort spent yield adequate rewardsIdeally, a target return of 12%-15% should be achievable after accounting for all expenses and commissions while including dividends.

Long-term investors who hold onto stocks consistently tend to realize better returns compared to those who frequently buy and sell

If an amateur investor decides to turn over their entire portfolio annually, incurring a 4% commission right off the bat translates into an immediate 4% lossTherefore, to achieve a net return of 12%-15%, their selected stocks must yield returns of 16%-19%. Frequent trading makes it increasingly challenging to outperform index funds or diversified investment options.

While inherent risks exist, if the average market return over ten years is 10%, an amateur investor achieving a 15% annual return can significantly outpace the market averagesFor instance, if their starting investment is $10,000, achieving a 15% return would yield approximately $40,455, compared to just $25,937 if averaged at 10%.

Building a portfolio capable of generating 12%-15% returns raises the question of optimal stock quantityThe debate continues on whether it’s better to concentrate investments versus diversify

On one side, investors are encouraged to focus all their resources into one or two strong stocks, while the opposing viewpoint suggests spreading risk among several investments to avoid vulnerability.

From Lynch's perspective, a well-balanced portfolio should consist of stocks with the following characteristics: ① A personal understanding gained from experience allows insightful knowledge of the company; ② Through careful assessment, the company displays impressive growth potentialThis evaluation might lead to discovering just one or several viable stocks; the number alone is less important than their quality.

While it’s wise to diversify, it’s inappropriate to allocate all funds into a single stock, as unforeseen events can adversely affect even the most vigorously analyzed company

Lynch therefore recommends that smaller portfolios should hold between 3 to 10 stocksThis moderate distribution can yield multiple benefits:

① The more stocks held, the greater the chances of discovering a "10-bagger" or tenfold investment returnAmong several promising growth companies, it's often surprising which one thrives the mostSince unpredictability is inherent in investing, transitioning from holding only one stock to several significantly increases the probability of unexpected gains.

② Holding multiple stocks enhances flexibility in reallocating funds as needed, integral to Lynch's investment strategyThe Magellan Fund, under Lynch's stewardship, broadly encompassed around 1,400 stocks, with significant capital concentrated in roughly 100 stocks, while 2/3 of assets lay in 200, and only a small fraction spread thinly across 500 marginal investment opportunities.

Among stocks identified by Lynch, slow-growth companies symbolize low-risk, low-return investments, as expectations for earnings growth are minimal; thus, stock prices are similarly restrained

Conversely, stable-growth stocks present low risk and medium returns, where companies like Coca-Cola could yield profits of around 50% in robust years but might also incur losses around 20% during downturnsHidden assets stocks embody low risk with potentially high rewards, provided a correct evaluation of underlying asset values is made.

Cyclical stocks can embody low-risk, high-return profiles or high-risk, low-return outcomes; success relies heavily on accurately forecasting business cyclesPredictions could yield tenfold returns if successful, or an 80%-90% loss if miscalculatedSimilarly, speculative "ten-bagger" opportunities reside within rapidly growing or turnaround companies, both tiers carrying significant risks for potentially massive rewards.

No single method can quantitatively define the relationship between risk and return

The key lies in investing in stocks of companies one sincerely understandsPurchasing stable-growth stock aims somewhat to mitigate investment risk, yet overpaying could inadvertently amplify itIf stocks are purchased at inflated prices, considerable gains will elude investors, even following a firm’s operational successes.

Some investors tend to offload ‘winners’—stocks that have appreciated—while clinging on to ‘losers’—those that have depreciatedSuch a strategy resembles “pulling out flowers to water weeds.” Others occasionally reverse this behavior to maintain underperformers while selling successful stocks, leading to comparably poor outcomesBoth approaches overlook that stock price fluctuations do not reliably indicate the company's fundamental shiftsOften, current stock prices might align inversely with business fundamentals.

Lynch advocates a more effective strategy wherein stock purchase and sale decisions pivot based on price relative to fundamental value