Investing mistakes are unavoidable. Everyone makes them. So it’s not a matter of if, but when. The question is what will do once you realized you’ve made a mistake?
Peter Lynch has the answer. In a 1980 appearance on Wall Street Week, Lynch highlights mistakes he’s had first-hand experience with like not knowing what you own or trying to catch a falling knife while ignoring fundamentals.
But Lynch has a rule for dealing with his mistakes. The instant he realizes he’s made a mistake, he gets out.
Unfortunately, many investors turn one mistake into many. They compound the problem.
Our first reaction toward losses is to make the money back. So the next mistake starts with wanting to get back to even. Which rarely goes as planned. Instead, we turn a small loss into a bigger loss. But that’s compounded by the opportunity cost of putting those dollars to work somewhere else.
So Lynch’s rule is difficult to follow but the best solution for mistakes is to sell immediately. Cut your losses. Learn from it, if you can. Move on.
It’s never easy to deal with mistakes but the goal with any mistake is to limit the damage.
Louis Rukeyser: Peter Lynch is a fundamentalist. That is, he researches the very basics of a company. Such as its earnings prospects and who its managers are before deciding which stocks to buy. He does this with outstanding success. In a recent survey, the mutual fund he manages, Fidelity Magellan, rated as the best performing mutual fund of all over the last 10 years…
How do you decide which stocks to buy?
Peter Lynch: Well, Lou, I try and find basically two types of companies. One would be a major company that’s had earnings problems in an industry that’s been depressed and the earnings are about to turn up. And sometime in the future, I don’t know, but perhaps in the next six months or the next year, major moves in companies usually occur. This is a dramatic change in profits.
The second type of company would be a small successful company that grows to a major-sized company over a long period of time.
Louis Rukeyser: Do you ignore the kind of technical things that someone like Stan looks at. Are you not concerned with how popular a stock is, for example?
Peter Lynch: I look at some technical indicators. I want to know whether there’s been a major brokerage report written on it. If there’s been several brokerage reports written on it recently, that’ of concern to me. And whether there’s a lot of institutional ownership. If there’s a lot of institutional ownership, I regard that as a negative. There’s very little, I regard that as a positive. Some people would regard that as technical analysis.
Louis Rukeyser: Many people believe that with you big institutional investors in the field, the individual doesn’t have a chance. What’s your feeling?
Peter Lynch: I think that the individual investor has several edges. First of all, his edge would be that he only has to convince himself. Perhaps he has to convince the husband or the wife but he can do it on his own.
Also, he doesn’t have to buy 100 stocks. He only has to buy three or five.
And they work in a particular industry. That’s what I think they should get an edge on. They’re in the tire industry. They’re in the rubber industry. They see a dramatic turn way before I do. Or they see a local company that’s terrific. They find a local product. I’ve had many examples of that. They’re years ahead of me. They’re professionals.
Louis Rukeyser: You said three to five stocks. Was that a number you picked out of a hat or do you think that’s a sensible number for a starting investor?
Peter Lynch: Well, I think at least three to five. I think if you find several companies that you like, I’ve done this before, and you pick one you’ll always pick the wrong one. It’s invariable. So you pick all five and something will work.
And then you keep learning as time goes by because I’ve found there’s almost no relationship with what a stock does in the first few months I’ve owned it. Some stocks have gone up and I felt good about them and they’ve been dogs. And some stocks have gone down and the fundamentals get better and I bought more of them and they were terrific. So I don’t think you want to draw too much of a conclusion at the start of buying a stock and what it’s going to do for you.
Louis Rukeyser: What do you think is the biggest mistake most investors make?
Peter Lynch: Well, I think that the single biggest mistake is they don’t do research. People go to the library and they do incredible research on a microwave oven. And then they’ll go out and spend $10,000 on a stock because they heard a tip on the bus. I think the biggest mistake is they don’t know what they own.
And the other one is they buy on the potential of something. They hear a terrific, potential story but the profits aren’t there. And I’ve found what you really want to do is, when you start to hear this, you just have to blackout. You have to think of a movie you went to recently because the story’s very appealing. You just have to get on to some other subject because you have to tune in later on these things. I don’t think you want to bite on the potential of something. You want to bite on the results.
Louis Rukeyser: Okay, you say they don’t do the research. We’re talking now the beginning investors. They must be thinking, how in the world can I do the research. What’s your answer to that?
Peter Lynch: Well, first of all, they should know what we call – it’s sort of a fun term in business – the story. They should know what’s underneath this company. Why do they own it? What are they looking for to happen? Then they can watch that unfold.
Today, the annual reports are much better than they were five years ago. It explains company’s profits by division. So if somebody’s trying to buy and they had a terrific fundamental story on plastics and they buy General Electric for it and it’s one percent of General Electric they’ve made a mistake.
So they should know what they’re looking for in a company. And as long as that’s happening, they can call the treasurer. They can get on the mailing list. They can get the employee news. You’d be amazed who’ll answer the telephone when you own a hundred shares of the stock.
Louis Rukeyser: Many people say that advisors always tell them how to buy a stock. They never tell them how to sell a stock. When do you decide to sell a stock?
Peter Lynch: What I try and do is I try and sell stocks because something else is more attractive. Stock A is simply more attractive than Stock B. I don’t try and find out the last quarter, the last eighth, the last 10 points.
And my second rule – this is the hardest one to follow – if I make a mistake, I try and sell it. If I’m looking for something to happen – some product to work, the business to get better – and it’s clear that I’m wrong – this is the key thing – you really have to sell it. It’s difficult to do. But you just want to just hope and pray because you can wait for years to go on.
And the third thing, I think, is what I call bottom fishing. A stock, Avon Products, goes from 150 to 90. On that basis alone, they buy the stock. And then, you know, it can go to 18 as far as we know. A stock that’s down combined with a good fundamental story is good but just buying on that basis alone is very dangerous.
Wall Street Week with Louis Rukeyser