Ten investing lessons from legendary fund manager - Peter Lynch

1. Stay within your circle of competence

In other words, invest in what you understand. This means you should understand how a company makes money. Once you understand that, you will be able to think about the business intelligently and assess the probability of the business succeeding in future.

If you don’t understand it, don’t invest in it.

2. Buy great companies

I agree with this one wholeheartedly. Except I would say, go one better and buy extraordinary companies. What makes a great company is probably a topic on its own, but it will suffice to say buy companies that generate lots of free cash flow. 

We explained free cash flow here.

3. Let your winners run

This is about managing a portfolio. When a stock goes up, the temptation is to sell it and take the cash. That way you make the gain real.

Conversely, when a stock has gone down, the temptation is to hang on until it goes back up (if it ever does). The reason is because you don’t want to make the loss real.

Lynch’s advice here is - keep your winners and sell your losers.

4. Everyone has the mental ability to make money in stocks

Some of the best fund companies try to make it seem like they have a 6^th sense about investing. That reminds me, a couple of weeks ago, I saw an investment article with a corny opening line about a fund manager, it said “[name] believe his critical faculties set him apart from his rivals”.

I’ll admit, I laughed when I saw it. After all, what does that mean? Is he smarter than everyone else? If yes, how does he know?

The investment game is not one that rewards intelligence. High IQ can get you in real trouble – read about “Long-Term Capital Management” which was led by Nobel Prize winners. They lost $4 billion.

Investing also rewards luck, timing, consistency and good old hard work. Some of the wealthiest people I know, are ordinary people, who do the basics right.

The good news for the rest of us with normal mental abilities is that we can also succeed and make money in stocks. Don’t get me wrong, it takes work and knowledge, but it’s doable.

5. You are an owner of a business when you buy a stock

This mindset is easier said than done. But if you can get this right, it will change your entire investing strategy. Think like an owner. Don’t let the slightest problem at the company or in the economy scare you into selling your stock. You would never do that if you owned the business privately, don’t do it because it trades publicly.

Here’s a link to our article on developing your own investment philosophy.

6. Focus on the fundamentals of the business

This ties into the previous point. If you focus on the fundamentals of the business and pick companies with good fundamentals, the stock price will follow.

7. Buy healthy companies

A company cannot go bankrupt if it doesn’t have any debt. The lesson here is to look at the strength of the balance sheet. How much of the assets are funded with debt and how much is funded with equity? The more a business is equity funded or the more cash it generates, the better chance it has of weathering the storms.

But don’t misunderstand the point, this does not mean only investing in businesses without debt. Almost all businesses have debt, even the good ones. What it means, is invest in businesses that don’t need debt to survive, but rather that choose to use it because they can afford to.

If you are looking at balance sheet ratios, think about capital structure and debt coverage ratios:

• Equity / assets

• Interest / EBIT

• Total debt / EBITDA

• Total debt / Free cash flow

8. Accept that there will be losses periodically

No matter how great the companies that you pick, from time to time, happenings in the business or in the stock market will result in losses. Don’t worry about it, you don’t have to get every investment correct. You only have to make more on the winners than what you lose on the losers.

9. Use common sense

Focus on the bigger picture when investing. Don’t get caught up the news, politics and quarterly reporting. Those are all small picture.

The big picture is will this company’s products be needed a decade from now and is the management doing a good job of running this business? If you can answer yes to both of those, half your investment worrying is done.

10. Don’t try to time the market

As the old saying goes, “it’s not about timing the market, it’s about time in the market”. We shared this sentiment in last week’s newsletter when we said “you got to be in it to win it”.

Invest regularly and let your money work for you. Don’t worry about trying to time a downturn to buy in, or a peak to sell out. That is impossible.

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