Peter Lynch delivered a 29% annualized return between 1977 and 1990 when managing the Magellan Fund. He was able to achieve this feat partly by having a thorough understanding of the companies he bought and held, as well as the sectors in which they operated.
Indeed, he has previously spoken about the importance of thoroughly researching companies before buying them. As he once said:
“Never invest in any company before you’ve done the homework on the company’s earnings prospects, financial condition, competitive position, plans for expansion and so forth… Know what you own, and know why you own it.”
Buying on a whim
However, not all investors follow the same strategy when adding stocks to their portfolio. In fact, it is surprising how many investors purchase stocks based on them having a positive experience with the company from a customer perspective.
Meanwhile, other investors buy shares in companies based on tips from friends or family, or from financial journalists. Clearly, their views may be highly relevant to an individual’s investment plans. However, they may have a different time horizon, tolerance of risk or outlook. This can mean that said investment turns out to represent an inefficient allocation of capital for the investor receiving the advice.
A dangerous strategy
Of course, purchasing stocks without undertaking thorough due diligence may be more prevalent during today’s bull market. Investor confidence is generally high during periods of stock market growth. This could lead them to underestimate the risks facing a business or industry. They may adopt an attitude that an investment will end up being successful because it has performed well in the recent past and that this trend is bound to continue in future.
This is arguably a very dangerous strategy. The stock market and the economy have always experienced booms and busts. They are impossible to accurately predict ahead of time. Therefore, following Lynch’s advice and checking the financial standing of a business and other fundamental characteristics could be crucial even during periods of rapid economic and stock market expansion. Due diligence can push investors toward purchasing companies that have the financial means to overcome unexpected difficulties that have historically occurred at relatively frequent intervals.
Effort can equal higher rewards
Doing your homework before buying a stock can also present superior reward opportunities, as well as lower risks. Due diligence may help an investor to unearth superior opportunities than they, their peers or commentators have previously found. For example, when analyzing the competitive position of a company, they may find a better buying opportunity elsewhere in the same sector.
Clearly, time is required to thoroughly analyze stocks prior to purchasing them. However, it is well worth the effort to obtain relatively attractive risk-reward opportunities. After all, investors work hard and make sacrifices to generate the capital available to buy stocks. It seems logical that similar levels of effort should be given to deciding where to apportion it.
