There are two ways the average investor can outperform Wall Street and the rest of the stock market, Peter Lynch noted in an article in 1997.
These two methods were either 1) take advantage of the fact they're an amateur or 2) take advantage of a personal edge.
As the former fund manager went on to note in the article, ever investor has an edge, it is "just a matter of identifying it."
Lynch and Warren Buffett
These comments were very similar to Warren Buffett (Trades, Portfolio)'s principle of the circle of competence.
Buffett has long stated that investors should only buy assets they understand, i.e. assets that fall inside their circle of competence. The Oracle of Omaha has said that if an investor does not understand something, they should stay away.
Some people might view this idea as nonsensical. They might ask, how is it possible to beat the market if you are not reviewing all potential investment opportunities? That is and isn't true. You could beat the market if you could understand every investment opportunity, but no one is smart enough to do that. It can take years to build a deep understanding of a specific sector or industry if you devote 100% of your time to the project.
There's nothing wrong with sticking to what you know. A lot of investors have made a significant amount of money doing just that.
Charlie Munger (Trades, Portfolio) has highlighted the case of a friend of his who became a billionaire just by investing in real estate within one square mile of a single university campus. This was his circle of competence, and he stayed within it.
Stick with what you know
In his 1997 article, Lynch explained just how easy it is for the average investor to find something they know and stick with it. Specifically, he wrote:
"This is where it helps to have identified your personal investor's edge. What is it that you know a lot about? Maybe your edge comes from your profession or a hobby. Maybe it comes just from being a parent. An entire generation of Americans grew up on Gerber's baby food, and Gerber's stock was a 100-bagger. If you put your money where your baby's mouth was, you turned $10,000 into $1 million. Fifty-baggers like Home Depot (HD, Financial), Wal-Mart (WMT, Financial), and Dunkin' Donuts (DNKN, Financial) were obvious success stories to large crowds of do-it-yourselfers, shoppers, and policemen. Mention any of these at a party, though, and you're likely to get the predictable reaction: "Chances like that don't come along anymore."
This statement is still relevant today. We are constantly bombarded with news and views reviewing and explaining what could potentially be the next most incredible investment opportunity. The chances are, it won't be. Sticking with what you know is likely to produce much better returns in the long-term than jumping into something that seems to be the next big thing.
The illustrations Lynch gave in 1997 are the perfect examples of the sorts of businesses anyone can understand. Even if these businesses have moved on from their growth stages, they could still be the best investments for a portfolio purely because they are well-known companies.
If an investor owns stock in Wal-Mart, where they shop every day, for example, they are more likely to hold onto the security through a downturn because they can see how the business is operating on a day-to-day basis.
This is one of the most underrated parts of investing strategy. Owning household names might not produce the most substantial investment returns. Still, from a psychological perspective, these securities are easier to hold in the long run, and that's where the real money is made.
Disclosure: The author owns no share mentioned.
Read more here:
- 3 Important Investing Lessons From Peter Lynch
- Peter Lynch on the Challenges of Investing in Biotech Stocks
- What Investors Should Know Before Following Ray Dalio's 'Cash Is Trash' Mentality
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