Knowledge Is Power

“The single most important thing to me in the stock market, for anyone, is to know what you own.” — Peter Lynch, famed Fidelity portfolio manager

Peter Lynch is one of the most successful and well-known investors of all time. Lynch is the legendary former manager of the Magellan Fund. At age 33, he took over the fund and ran it for 13 years until his success allowed him to retire at age 46. Back in my stock trader days at Fidelity Investments, I remember him stopping by to provide words of wisdom to our team. What stood out (besides his signature whitish hair) was the depth of investment and market knowledge that he possessed. What he said above sounds like pure common sense. But most investors don’t adhere to this rule—and it can be one of the biggest mistakes that they make.

When you invest in the stock of a company, do you understand that company's business? How does it make money? Does it have a competitive advantage in its industry? Morningstar created a proprietary data point called an "economic moat," which refers to how likely a company is to keep competitors at bay for an extended period. The wider the moat, the better.

Marijuana and cryptocurrency are two recent examples of investments that people have bought a lot of without knowing much about them at all. They are what I would call “cocktail party” buys, as you hear about them at parties and then go out and invest the next day for fear of missing out. (Millennials call this the FOMO!) I fancy myself a pretty educated investor who has been working in the investment industry for more than 25 years. But I could not tell you how any aspects of cryptocurrency like blockchain and/or bitcoin make money for companies.

Emotion Is Not Your Friend

“Everyone says they’re a long-term investor until the market has one of its major corrections.” — Peter Lynch

A correction is Wall Street’s term to describe when an index like the S&P 500 or the Dow Jones Industrial Average, or even an individual stock, has fallen 10 percent or more from a recent high. A bear market is a condition in which securities prices fall 20 percent or more from recent highs. The S&P 500 has had 22 corrections since 1945 and 12 bear markets. On average, bear markets have lasted 14 months. When you, like Bud Fox in the movie Wall Street, “get emotional about stock,” it can hurt your returns.

The annual study done by DALBAR shows that in 2018, the average equity fund investor lost twice the money of the S&P 500 (9.42 percent loss versus 4.38 percent loss). Human emotion is beneficial in most cases—but not in investing. It leads to short-term thinking and unrealistic expectations about your current and future returns. This type of thinking can lead to the following common investment mistakes:

• Panicking in the short term and selling when an investment is underperforming

• Churning or high turnover in your portfolio, adding to the cost of investing

• Falling in love with a company and not selling it when you have made a profit on paper (It is okay to make a profit! You will have to pay capital gains taxes, but that is okay, too.)

• Waiting to get even, meaning that you don’t want to recognize a loss (This decision can lead to more losses, as well as an opportunity cost as you could be reallocating monies elsewhere.)

Diversify: Finding the Balance Between Risk and Uncertainty

 “If you own stocks, there’s always something to worry about. You can’t get away from it.” — Peter Lynch

Investing involves both risk and uncertainty. You must take those on in order to possibly reap some financial rewards. To reduce that risk, you must diversify into a variety of different investments, ideally with some not correlating with one another too much. Lynch profoundly said the following about this very topic:

“I’ve always found that if you find 10 stocks you really like and buy 3, you always pick the wrong 3. So I just buy all 10.”

It is analogous to going to a casino and placing all of your chips on just one number at a roulette table. Your potential reward may be greater; however, your odds of winning are not so good.

Buy Low, Sell High

“I’ve found that when the market’s going down and you buy funds wisely, at some point in the future you will be happy.” — Peter Lynch

I get it. Investing, especially in down markets, can be nerve racking. A few years back, Rob Arnott, a well-known portfolio manager at PIMCO, came to speak to us at Commonwealth. He made a great point about how investors do the opposite of what they do in every other aspect of their lives; that is, they buy stocks when they are expensive (rising) and sell them when they are cheap (falling). This point is so true. Think about that.

As an example, back in 1995, I drove a “cool” 1986 Chevy Beretta. (The name alone screams the Fonz!) When I wanted to “mature” to a more practical Honda Accord (not cool but agreeable), I knew that I had to sell the Chevy. Following the behavior of an average investor, I would have traded it in or “sold it” to the Honda dealer only after it offered me $3K for the car instead of the $4K it offered me a month before. If you “like” a stock that is priced at $20 before a market correction, you should love it at $10!

Words of Investing Wisdom

So, how do we get back to investing basics? Using knowledge, not getting emotional, diversifying, and buying low (selling high) are all ways to turn a bad time for many into a good time for you.

Editor’s Note: The original version of this article appeared on the Independent Market Observer.