Many investors, especially when they’re starting out, look for the best stocks, the fastest growers, the highest quality, or the quickest buck. It almost makes sense, at first but doing it that way and making money is harder than it appears.
A simpler, yet important approach, is to focus first on things to avoid.
Avoid the worst. Avoid expensive. Avoid things you don’t understand.
In a dive into Peter Lynch’s writing, I came across an article he wrote where he lays out 14 investing rules. Lynch is most commonly known for his “know what you own” stance. His rules also include some things worth avoiding.
What’s interesting about his piece is that it was written exactly 3 years (March 1997) before the internet bubble burst (March 10, 2000, was the Nasdaq peak). The internet boom ushered in a new line of thinking that ignored many of the old tried and true rules. Eyeballs became the go-to measuring stick over profits. Somehow it didn’t turn out too well for those who failed to follow at least one of Lynch’s rules.
One of the hard parts about investing is sticking with a good strategy while you watch other people make more money than you. The internet boom was one of those times (turns out, Keeping up with the Jones is a poor benchmark in life and investing).
Most of Lynch’s rules fall under two areas: know what you own (and why) and know what to avoid. If you read either of Lynch’s first two books – One Up on Wall Street and Beating the Street – these rules will be a nice reminder. Here’s Lynch:
Find your edge and put it to work by adhering to the following rules:
- With every stock you own, keep track of its story in a logbook. Note any new developments and pay close attention to earnings. Is this a growth play, a cyclical play, or a value play? Stocks do well for a reason and do poorly for a reason. Make sure you know the reasons.
- Pay attention to facts, not forecasts.
- Ask yourself: What will I make if I’m right, and what could I lose if I’m wrong? Look for a risk-reward ratio of three to one or better.
- Before you invest, check the balance sheet to see if the company is financially sound.
- Don’t buy options, and don’t invest on margin. With options, time works against you, and if you’re on margin, a drop in the market can wipe you out.
- When several insiders are buying the company’s stock at the same time, it’s a positive.
- Average investors should be able to monitor five to ten companies at a time, but nobody is forcing you to own any of them. If you like seven, buy seven. If you like three, buy three. If you like zero, buy zero.
- Be patient. The stocks that have been most rewarding to me have made their greatest gains in the third or fourth year I owned them. A few took ten years.
- Enter early — but not too early. I often think of investing in growth companies in terms of baseball. Try to join the game in the third inning, because a company has proved itself by then. If you buy before the lineup is announced, you’re taking an unnecessary risk. There’s plenty of time (10 to 15 years in some cases) between the third and the seventh innings, which is where the 10- to 50-baggers are made. If you buy in the late innings, you may be too late.
- Don’t buy “cheap” stocks just because they’re cheap. Buy them because the fundamentals are improving.
- Buy small companies after they’ve had a chance to prove they can make a profit.
- Long shots usually backfire or become “no shots.”
- If you buy a stock for the dividend, make sure the company can comfortably afford to pay the dividend out of its earnings, even in an economic slump.
- Investigate ten companies and you’re likely to find one with bright prospects that aren’t reflected in the price. Investigate 50 and you’re likely to find 5.
Use Your Edge – Worth Magazine March 1997
This post was originally published on April 19, 2017.