Principles of Wealth #23*

Tuesday, December 18, 2018

Delray Beach, FL.- Wall Street promotes the idea that investing in stocks and bonds is the sensible way to grow rich. But a strategy that focuses solely or even primarily on stocks and bonds is a flawed strategy. The prudent wealth builder knows this.

Pat told me about the great delivery service he’s been getting from Company A. “The other guys,” he said, “they just drop the packages over the fence. But Company A’s guy drives in and delivers my packages to the door.”

“I really like this company,” Pat said. “So I did some research. And based on what I learned, I think it’s a good investment. I’m going to buy their stock.”

It sounds smart. It reminds me of how, in One Up on Wall Street, Peter Lynch described his amazing success as the manager of Magellan Fund, which made 29.2% from 1977 to 1990, bringing the assets under management from $18 million to $14 billion.

“Invest in what you know,” was Lynch’s most popular investment rule. He attributed his success to his habit of going beyond the spreadsheets and looking under the hoods of the businesses he bought. He argued that the average investor could do the same.

He was wrong about that. And there’s a good chance that Pat will be wrong about the trade he’s about to make.

Why do I say that?

Because the average investor can’t possibly know enough about the stocks he buys to achieve a 29.2% return over a long stretch of time. The average investor, in fact, can’t even achieve the average overall market ROI of 9% to 10% over time. The average investor makes a third of that, if he’s lucky.

When Lynch talked about investing in companies you know, he meant that you should know more than you can ascertain from the public filings, from the balance sheet, the P&Ls, metrics such as P/E ratios, etc. He liked to get inside the industry a bit, get to know the players, ask questions of the execs and the frontline workers.

Lynch had the power to do that. The average investor doesn’t. At best he can do the kind of research that Pat did on Company A. But that’s not nearly enough. He’s still very much on the outside.

I’ve been “inside” the investment advisory business for more than 30 years. I have known dozens and dozens of managers and analysts. I know many of the best-known gurus. Most of them are smart. Most of them are driven. Some of them beat the market for a while. But few can match Lynch’s record. (And Lynch’s performance, let’s not forget, ended after 13 years.) So how can the average investor expect to do what even the pros can’t?

No matter what you hear from Wall Street, the stock and bond markets are not there to help the average investor get rich. They are there to provide fees and commissions to brokers, managers, and analysts.

Buying stocks and bonds is a sensible thing to do if you see it as a part, and only a part, of an overall investment strategy. What the smart investor should expect from his stocks and bonds is what the market is willing to give average investors. And that is average returns – 9% to 10%. Not 29.2%.

Now I agree with Lynch and I’ve said it a thousand times:  The smart way to build wealth is to invest in what you know. But when I say know, I mean know inside and out. I mean know with your eyes closed. I mean know the beating heart of it.

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