One Up on Wall Street – Part I: The Basics of Investing

Introduction

This new series is my take on One Up on Wallstreet by Peter Lynch. Lynch is a famous investor of the past with an incredible track record of success (with an average return of ~30% compounded annually in the period of 1977-1990). The book, on its own merits, is an investor classic. The simplicity of Lynch’s explanation of the investment process drives the book’s popularity. Although published in 1989, the novel is still extremely relevant in understanding modern capital markets.

I will write this series in three articles, which will parallel the breakdown of the book. This series of articles is meant to summarize and elaborate on the most important points that Lynch makes in his book. I will assist the reader by adding more recent examples and delving deeper to hit home Lynch’s basic ideas.

In the first section of the book, Lynch offers beginner-level lessons on picking stocks. He emphasizes staying within your circle of competence (i.e., picking companies and markets you have working knowledge in), which is a central tenant of investing. Academics (like Bruce Greenwald) would allude to the fact that this will make the investor more likely to be on the right side of the trade.

1) The Stock-picker

An individual is not born to be a stock-picker. The retail investor does not require an innate ability to be successful in the field. No skill in timing, physical feats of reacting quickly to news, or ability to see into the future is necessary.

Choosing the right stock to buy is more of an art form than a science. The idea that complex arithmetic and technical analysis is what it takes to be a successful investor is a façade that the media portrays. An individual obtains the level of math required to do well in the stock market in the first few years of high school. Logic is the most important discipline to investing for the retail investor. A basic understanding of common fallacies and psychological misconceptions is fundamental (and can serve as the basis of their own respective articles).

2) The Oxymoron: “Professional Investing”

Lynch wrote this chapter for the purpose of describing your main competitor, the big and scary institutional investor. He reassures the retail investor that this competitor, when you are buying and selling stocks, is not as frightening as you may initially think. Rather, the institutional investor is a beast that rules and regulations tame. These rules and regulations make institutional investors easy to beat with the appropriate tactics. I will describe a few of the shackles that he mentions:

(1)   Homogenous: The minds of the people in the investment business are quite similar. They read the same newspapers, listen to the same podcasts, and have similar educational backgrounds. This background tends to include quite general business school knowledge and not a hyper-focus on one specific industry. Many retail investors do not have this trait. Rather, retail investors tend to focus on one industry and, primarily, the industry in which they work on a daily basis. For example, a video game designer will tend to have competence in gaming companies and is better suited to determine the integrity of the products within that industry.

(2)   Street Lag: A stock is not truly attractive to professional funds until many institutions and analysts have announced their approval of the stock. This scope limits the world of stocks that a fund is willing to exploit. A retail investor does not have to deal with these same issues and has a wider scope of potential opportunities.

(3)   Avoidance: The cult of institutional investors operates on a key survival theory: “You’ll never lose your job losing your client’s money in Apple.” Thus, the average portfolio manager would take the side of losing a small amount on a large company than the chance of making a substantial amount on an unknown company. The retail investor is advantaged by the fact that they only answer to themselves and not investors. 

(4)   Size: The amount of money that institutional investors need to invest limits the companies into which they can afford to research. These big institutions must focus on companies with a high enough market capitalization to make a noteworthy return on their overall portfolio. The retail investor will be investing smaller amounts and will have a bigger universe of opportunities to exploit.

(5)   Policy: Internal/external rules and regulations imposed on the fund can inhibit logical investments. For example, the fund may be restricted from investing in certain industries because they are too volatile, or the fund may be limited in the amount of money that it can allocate to one industry.

(6)   Bureaucracy: The length of time before institutions act can be extensive. These managers must spend a significant amount of time briefing their investments and discussing their ideas with one another. This procedure can result in many missed opportunities as the stock price climbs during this period. The benefit to the retail investor is that these bargains exist for a longer period when less people are quick to act, which accords with economic principles.

3) Personal Issues

Before buying any individual stocks, the stock-picker must ask themselves three questions: (i) do I own a house, (ii) do I need the money, and (iii) do I have the characteristics that will make me a successful investor?

(i)             Do I Own a House?

Lynch makes two assumptions in this section of the book: (1) the house is an asset and (2) the price of a house always goes up in the long-term. Thus, he believes buying a house is the foolproof way of investing for the layman, which is best explained by an example. If you buy a house with leverage (e.g., 20% down payment), then even a 5% increase on the market value of a house is tremendous. A seemingly nominal market value increase is significant because the 5% appreciation applies to the 80% of the house price that the bank provides. A $200,000 down payment on a $1,000,000 house that goes to $1,050,000 is a 25% gain on your initial $200,000. 

I take a few issues with Lynch’s view. The first is that this outlook presumes that house prices will undeniably increase. The problem with this assumption is that there are many market bubbles in different regional areas. These market bubbles may burst in the future. If that is the case, then the investor is taken out of the game for a long time to cover their losses. This is a risk in buying on margin that everyone needs to be worried about. In essence, a 5% decrease in the house value is a 25% decrease on your initial investment as you are equally responsible for the losses. As a result, the retail investor should not take these massive purchases lightly.

My second concern relates to the drawbacks associated with how you can extract value from your house. To me, there are only three ways to reap the benefit of the increase over time. One way is to downsize your house and pocket the extra money. This approach economically exchanges your higher standard of living for cash, which is hard to do after years of getting accustomed and emotionally attached to your house. The second approach is to borrow against the value of your house. If the withdrawals are appropriately managed, then your trust would sell off the house to pay back these bank loans. A parent wishing to gift the family home to their kids would find this equally unappealing. The final approach is to rent the basement of your house. Again, you sacrifice your living standards, and privacy, for this cashflow.

(ii)            Do I Need the Money?

To quote Lynch, “only invest what you could afford to lose without that loss having any effect on your daily life in the foreseeable future.” Lynch’s idea is that your investment thesis needs time to play out. A failure to stick it out can ruin a great idea. The retail investor must allocate an appropriate amount of funds to stock-picking according to their lifestyle expenses. For example, money required for tuition in the following year should not be invested today. Because if you are right and the market required two years to realize this, then you face a risk of selling your stocks at a price that is below the inherent value.

Consider META shares in July 2022. You could have bought the stock at $160/share and made a huge profit in 14-months by selling at $320/share. But a student who uses their academic loans to buy the shares in July faces timing risk. If the last day to pay tuition is November 2022, then the student can potentially lose ~50% of their money by having to sell their META stock at $90/share.

(iii)          Do I Possess the Traits of a Successful Investor?

Lynch lists various qualities that one needs to be willing to display in the investing process to be successful: patience, self-reliance, common sense, pain tolerance, detachment, persistence, humility, flexibility, initiative, and calm mindedness.

Lynch makes two additional observations. First, he notes that it does not take a genius to do well in the stock market. He notes that it is more likely for geniuses to be interested in the academic pursuit of explaining the stock market than the investing component. Second, he highlights the inherent disability that humans have in timing the market. This inability stems from the 3 Cs emotional circle: concern, complacency, and capitulation.

The retail investor is concerned when a good stock, which is not yet in their portfolio, drops in price. They question the underlying thesis of the company, and they are unable to act rationally on these discounted prices. They fall for the headlines that the media pushes. Fear sells. Then, the price bounces back up on good news and the investor buys at a higher price. They get complacent when the stock price is climbing higher and do not question whether the price of the stock and the value of the company align. Finally, when more bad news hits the investor’s stock and the price falls, the investor capitulates by selling their stock. The investor, attempting to prevent further losses, is acting under an emotional trance. Instead, an investor should assess the news objectively to determine whether there is a real risk of permanently losing the investor’s capital.

4) Is This a Good Market to Invest?

I do not know. Many individuals believe that if they outguess the market on matters such as inflation, interest rates, and recessions, they can win big on stocks because they are correlated to the trends in the general economy. However, the problem is that no one, including full-time analysts, can do this with any regularity. If these analysts could do that, then they would all be millionaires by now and not needing these brutal full-time (and then some), chaotic jobs. An amateur investor has no chance of forecasting these changes if the full-time analyst cannot.

As Warren Buffet says, “the stock market doesn’t exist. It is there only as a reference to see if anybody is offering to do anything foolish.”

5) Compound Interest

While Lynch does not designate a chapter to compounding interest, it is a fundamental topic that deserves special recognition. Compounding interest should frame an investor’s decision-making process at its core.  

A storytelling exercise will serve a great illustrative purpose. Once upon a time, in a land far away, a kingdom was ruled by Queen Kiki. The kingdom had a new popular boardgame making its way throughout the locals, which they began referring to as “chess.” Queen Kiki had her turn with the game and instantly became addicted to it. She wanted to award her loyal citizen, UJ, for his work. Queen Kiki asked UJ what he wanted in return for his invention. UJ, a simple man, just wanted rice. Queen Kiki, excited by such an easy proposition, asked how much. UJ cunningly requested to be repaid according to the chess board. He wanted one grain of rice placed on the first square of his 8x8 chess board. Then, on each adjacent square, the Queen shall double the number of grains. The end sequence would look something like this: 2, 4, 8, 16, 32 …

The problem with this scenario is that the final number is more rice than Queen Kiki had! It was even more rice than the Kingdom could feasibly obtain. It was even more than the earth could produce! Because a chess board has 64 squares and since the base number is 2, the math works out to being the following: 2⁶⁴ = 1.84 x 10¹⁹.

Let’s look at this from an investing perspective. Consider Lynch’s record of 30% a year for 13 years. An investor would be left with $30,290 for each $1,000 invested with Lynch over this 13-year period at this rate. Now, consider what would happen if the fund lost 20% in three of those years. The investor would then be left with $7,060 for each $1,000 invested with Lynch over the 13-years at this rate. Next, consider what would happen if the rate were 20% a year over the same period. The investor would then be left with $10,700 for each $1,000 invested with Lynch over this period at this rate. The difference is stark! The investor would be significantly better off if they consistently returned 20% annually than if they returned 30% annually (i.e., a rate 50% higher than the former) with three of those years being down years. Simply, the investor should avoid losses because they are hard to overcome.