Beating the Street (3 page)

What I've tried to get across is that the average investor isn't in the same ballpark with the Wall Street mutual-fund or pension-fund managers. The individual is free of a lot of the rules that make life difficult for the professionals. As an average investor, you don't have to own more than a handful of stocks and you can do the research in your spare time. If no company appeals to you at the moment, you can stay in cash and wait for a better opportunity. You don't have to compete with the neighbors, the way professionals do, by publishing your quarterly results in the local shopper.

Proof that average investors can do quite well for themselves, free of the burdens that weigh down the professionals, comes from the NAIC, the organization that represents 10,000 local investment clubs, which are made up of ordinary men and women. According to the NAIC, 69.4 percent of the local clubs managed to outperform the S&P 500 in 1992. More than half these clubs have beaten the S&P in four of the past five years. It appears that the investment clubs are getting more adept at picking stocks, by taking full advantage of their amateur status.

If you have done well as a stockpicker, it's probably because you have also exploited your natural advantage of being an amateur. You have researched your own investments and bought shares in great companies that Wall Street may have overlooked. The remarkable record of local mutual savings banks and S&Ls is powerful evidence that neighborhood investing pays off.

Misconception #2 is that Lynch thinks everybody should be out there with hand-held calculators, reading balance sheets, investigating companies, and buying stocks. In fact, millions of Americans should refrain from buying stocks. These are people who have no interest in investigating companies and cringe at the sight of a balance sheet, and who thumb through annual reports only for the pictures. The worst thing you can do is to invest in companies you know nothing about.

Unfortunately, buying stocks on ignorance is still a popular American pastime. Let's return to the sports analogy. When people discover they are no good at baseball or hockey, they put away their bats and their skates and they take up amateur golf or stamp collecting or gardening. But when people discover they are no good at picking stocks, they are likely to continue to do it anyway.

People who are no good at picking stocks are the very ones who say that they are “playing the market,” as if it is a game. When you “play the market” you're looking for instant gratification, without having to do any work. You're seeking the excitement that comes from owning one stock one week, and another the next, or from buying futures and options.

Playing the market is an incredibly damaging pastime. Players of the market may spend weeks studying their frequent flier miles, or poring over travel guides in order to carefully map out a trip, but they'll turn around and invest $10,000 in a company they know nothing about. Even people who are serious about their vacations get caught up in playing the market. The whole process is sloppy and ill-conceived.

This is a group I'd like to address, the chronic losers with a history of playing their hunches. They buy IBM at $100 a share because they sense it's overdue for a comeback or they buy a biotech stock or a riverboat casino stock because they've heard it's “hot.”

Whatever they can salvage from these losses they sink into deutschemark futures or call options on the S&P 500 because they have a feeling that the S&P 500 is going up this month. In the end they're more convinced than ever that Wall Street is a game, but that's because they've made it one.

Misconception #3 is that Lynch has it in for mutual funds. Why would I bite the hand that fed me so well? Equity mutual funds are the perfect solution for people who want to own stocks without doing their own research. Investors in equity funds have prospered handsomely in the past, and there's no reason to doubt they will continue to prosper in the future. There's no rule that says you can't own individual stocks
and
mutual funds. There's no rule that you can't own several mutual funds. Even in an equity fund that fails to beat the market average the long-term results are likely to be satisfying. The short-term results are less predictable, which is why you shouldn't buy equity mutual funds unless you know you can leave the money there for several years and tolerate the ups and downs.

I'm cheered by the evidence that individual investors are learning not to get scared out of their stocks or their equity mutual funds during market corrections, as occurred in October 1987. There was a scary period in 1989 when the Dow Jones Industrial Average dropped 200 points and another big drop of 500 points in 1990, and in both cases the general public was a net buyer of stocks in the aftermath. So perhaps the message about corrections being as routine as snowstorms, and not the end of the world, is beginning to sink in.

One message that hasn't sunk in, apparently, is that in the long run owning stocks is more rewarding than owning bonds and CDs. Recently, I was dismayed to discover that in the retirement accounts that thousands of people have opened at my own firm, Fidelity, only a small percentage of the money is invested in pure equity funds. Most of it has gone into money-market funds, or bond funds, or the equity income funds. Yet history shows that over a long period of time assets will grow much faster when they are 100 percent invested in stocks. The retirement account is the perfect place for stocks, because the money can sit there and grow for 10 to 30 years.

Escape from Bondage

A retired fund manager is qualified to give only investment advice, not spiritual advice, but what inspires me to retake the pulpit is that a majority in the congregation continue to favor bonds. Obviously, they must have slept through the last sermon,
One Up on Wall Street
, in which I tried to prove once and for all that putting money into stocks is far more profitable than putting it into bonds, certificates of deposit, or money-market accounts. Otherwise, why are 90 percent of the nation's investment dollars still parked in these inferior spots?

Throughout the 1980s, which was the second-best decade for stocks in modern history (only the 1950s were slightly more bountiful), the percentage of household assets invested in stocks declined! This percentage, in fact, has been declining steadily—from nearly 40 percent in the 1960s to 25 percent in 1980 to 17 percent in 1990. As the Dow Jones average and the other stock indexes quadrupled in value, a mass of investors was switching out of stocks. Even assets invested in equity mutual funds shrunk from around 70 percent in 1980 to 43 percent in 1990.

This calamity for the future of individual and national wealth cannot go unchallenged. Let me begin, then, where I left off the last time: if you hope to have more money tomorrow than you have today, you've got to put a chunk of your assets into stocks. Maybe we're going into a bear market and for the next two years or three years or even five years you'll wish you'd never heard of stocks. But the 20th century has been full of bear markets, not to mention recessions, and in spite of that the results are indisputable: sooner
or later, a portfolio of stocks or stock mutual funds will turn out to be a lot more valuable than a portfolio of bonds or CDs or money-market funds. There, I've said it again.

The most persuasive bit of proof I've discovered since I argued this point before can be found in the
Ibbotson SBBI Yearbook, 1993
,
chapter 1
, page 17, under the heading “Average Annual Return for the Decades 1926–1989.” This is a summary of the profits you would have made, per year, by investing your money in the S&P 500 stocks, small-company stocks, long-term government bonds, long-term corporate bonds, and short-term Treasury bills. The results are shown in
Table 1-1
.

The investment geniuses among us could have put all their money into the S&P 500 stocks in the 1920s, switched in 1929 to long-term corporate bonds and held these throughout the 1930s, moved into small-company stocks in the 1940s, back into the S&P 500 in the 1950s, back to small companies in the 1960s and the 1970s, and returned to the S&P 500 in the 1980s. The people who followed that inspired strategy are now all billionaires and living on the coast of France. I would have recommended it myself, had I been clever enough to know beforehand what was going to happen. In hindsight, it's quite obvious.

Since I've never met a single billionaire who made his or her fortune exactly in this fashion, I must assume that they are in short supply relative to the rest of us who exhibit normal intelligence. The rest of us have no way of predicting the next rare period in which bonds will outperform stocks. But the fact that it's only happened in one decade out of seven, the 1930s (the 1970s was a standoff), gives the dedicated stockpicker an advantage. By sticking with stocks all the time, the odds are six to one in our favor that we'll do better than the people who stick with bonds.

Moreover, the gains enjoyed by the bondholders in the rare decade when bonds beat stocks cannot possibly hope to make up for the huge advances made by stocks in periods such as the 1940s and the 1960s. Over the entire 64 years covered in the table, a $100,000 investment in long-term government bonds would now be worth $1.6 million, whereas the same amount invested in the S&P 500 would be worth $25.5 million. This leads me to Peter's Principle #2:

 

Gentlemen who prefer bonds don't know what they're missing.

Table I-1. AVERAGE ANNUAL RETURN

FIGURE 1-1

Yet we continue to be a nation of bondholders. Millions of people are devoted to collecting interest, which may or may not keep them slightly ahead of inflation, when they could be enjoying a 5–6 percent boost in their real net worth, above and beyond inflation, for years to come. Buy stocks! If this is the only lesson you learn from this book, then writing it will have been worth the trouble.

The debate over whether to invest in small stocks or big stocks, or how to choose the best stock mutual fund (all subjects of later chapters), is subordinate to the main point—whichever way you do it, big stocks, small stocks, or medium-sized stocks, buy stocks! I'm assuming, of course, that you go about your stockpicking or fundpicking in an intelligent manner, and that you don't get scared out of your stocks during corrections.

A second reason I've taken on this project is to further encourage the amateur investor not to give up on the rewarding pastime of
stockpicking. I've said before that an amateur who devotes a small amount of study to companies in an industry he or she knows something about can outperform 95 percent of the paid experts who manage the mutual funds, plus have fun in doing it.

A sizable crowd of mutual fund managers dismisses this notion as hooey, and some have called it “Lynch's ten-bagger of wind.” Nevertheless, my 2½ years away from Magellan have only strengthened my conviction that the amateur has the advantage. For non-believers on this point, I've stumbled onto some additional proof.

This can be found in
Chapter 1
, “The Miracle of St. Agnes,” which describes how a bunch of seventh graders at a Boston area parochial school have produced a two-year investment record that Wall Street professionals can only envy.

Meanwhile, a larger bunch of adult amateur investors claims to have bested their professional counterparts for many years in a row. These successful stockpickers belong to the hundreds of investment clubs sponsored by the National Association of Investors, and their annual rates of return have been just as enviable as those turned in by the students at St. Agnes.

Both bunches of amateurs have this in common: their stockpicking methods are much simpler and generally more rewarding than many of the more baroque techniques used by highly paid fund managers.

Whatever method you use to pick stocks or stock mutual funds, your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed. It isn't the head but the stomach that determines the fate of the stockpicker. The skittish investor, no matter how intelligent, is always susceptible to getting flushed out of the market by the brush beaters of doom.