Morningstar believes there are important lessons to be learned from the world's most successful investors. Here is the latest instalment in our series on their investment philosophies and strategies.

 

Peter Lynch boasts of one of the greatest investing track records of all time, serving as the portfolio manager of Fidelity's Magellan Fund from 1977 to 1990.

When Lynch became Magellan's manager in 1977, the fund had $20 million in assets. His strong track record drew investors in at a rapid rate, and by 1983 the fund's assets topped $1 billion. It went on to become the largest managed fund in the US with $13 billion in assets.

The sheer size of Magellan was part of Lynch's aura. No one else had managed such a big fund with so much success.

Over the 13 years with him at the helm, the fund delivered an annualised return of 29 per cent. Here are some words of wisdom from his two seminal books One Up on Wall Street and Beating the Street, that are still applicable to investors, even today.

On the number of stocks one must have in a portfolio

There's a long-standing debate between two factions of investment advisers: "Put all your eggs in one basket," and "Don't put all your eggs in one basket--it may have a hole in it."

Don't rely on a fixed number of stocks but investigate how good they are on a case-to-case basis. Of course, it is not safe to own just one stock because, in spite of your best efforts, it may be a victim of unforeseen circumstances.

It's best to own as many stocks as there are situations in which you have an edge or you have uncovered an exciting prospect that passes all the tests of research. That could be a single stock, or a dozen stocks.

There's no use diversifying into unknown companies just for the sake of diversity. That would be foolish.

On predicting the stock market

You don't have to be able to predict the stock market to make money in stocks. Things inside human beings make them terrible stock market timers.

The unwary investors pass in and out of three emotional states: concern, complacency, and capitulation.

He's concerned after the market has dropped or the economy has seemed to falter, which keeps him from buying good companies at bargain prices.

When he buys at higher prices, he gets complacent because he sees the stock price rise higher. In fact, this is the time he ought to be concerned and check the fundamentals.

Then finally when the stock crashes to prices below what he paid, he capitulates and sells in a snit.

Such investors fancy themselves to be long-term investors but only until the next big drop, at which point they quickly become short-term investors and sell out for huge losses.

People who succeed in the stock market accept periodic losses. Calamitous drops do not scare them out of the game. The trick is not to trust your gut feelings, but to discipline yourself to ignore them.

Invest in a company after you have done the homework on the company's earnings prospects, financial condition, competitive position, plans for expansion, and so forth. Stand by your stock as long as the fundamental story behind it has not changed.

On being contrarian

Some fancy themselves as contrarians, believing they can profit by zigging when the rest of the world is zagging. But it did not occur to them to become contrarian until that idea had already become so popular that contrarianism became the accepted view.

The true contrarian is not the investor who takes the opposite side of popular hot issues (shorting a stock that everyone else is buying). The true contrarian waits for things to cool down and buys the stock that nobody cares about.

Market declines are great opportunities to buy stocks in companies you like. Corrections push outstanding companies to bargain prices.

On playing the market

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

"Playing the market" is an incredibly damaging pastime. Players of the market may spend weeks planning a trip and hours studying their frequent flyer plans but will turn around and invest $10,000 in a company they know nothing about. This is sloppy and ill-conceived.

More often than not, they are chronic losers with a history of playing their hunches. In the end, they are more convinced than ever that investing in stocks is a game, but that's because they have made it one.

On investing in equity

The retirement account is the perfect place for stocks, because money can sit there and grow for 10 to 30 years. If you hope to have more money tomorrow than you do today, you have to put a major chunk of your assets into stocks.

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 equity managed funds will turn out to be a lot more valuable than a portfolio of bonds or debt or cash.

On picking funds

Reviewing the past performance of funds is a waste of time. Some people buy last year's biggest winner. This is particularly foolish. The one-year winner tends to be a success story because of a bet on a particular sector or industry or stock. Next year, this fund could be at the bottom of the list.

Picking future winners from past performance doesn't seem to work even when you use a three- or five-year record.

That's not to say you should not pick a fund with a good long-term record. But it's better to stick with a steady and consistent performer than to move in and out of funds, trying to catch the waves.

Also look at what happens to funds in a bear market: a) Some lose more than others, but gain more on the rebound b) Some lose less, but gain less c) Some lose more, but gain less. This last group is the one to avoid.

On investing in sector funds

If you are in the right sector at the right time, you can make a lot of money very fast. However, sector funds are not designed to give the whimsical stock-picker a new opportunity to follow hunches.

The best candidate for investing in sector funds is any individual with special knowledge about a commodity or the near-term prospects for a certain kind of business. This individual must be in a position to follow the latest developments in the sector they are investing in.

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Larissa Fernand is the editor of the Morningstar India website, where this article initially appeared.

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