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Robert Abbott
Robert Abbott
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Beating the Street: Peter Lynch on Mutual Funds

Advice on mutual funds from one of the greatest managers in history

October 07, 2019

Investing was supposed to get easier with mutual funds; after all, investors who lacked the time or inclination to study stocks could simply buy mutual funds. But a funny thing happened—funny in the ironic sense—so many mutual funds appeared on the market that picking a fund became no easier than picking stocks.

Peter Lynch, a legendary fund manager, aimed to provide an overview of mutual fund investing in chapter three of “Beating the Street,” a follow-up to his best-seller, "One Up on Wall Street: How To Use What You Already Know To Make Money In The Market."

Some of the details now are dated since “Beating the Street” was published in 1993, but the broad principles remain relevant to investors. Even by that year, he noted an important milestone: The number of mutual funds then exceeded the number of individual stocks trading on the New York and American stock exchanges combined.

Why so many? Lynch had this tongue-in-cheek response: “The latest emergency instructions for every firm on Wall Street? In Case of a Sudden Drop in Profits, Start Another Fund.”

Asset allocation

He then went on to discuss asset allocation, in the context of a non-profit organization he was advising. The organization’s previous manager had a basic 50-50 allocation of stocks and bonds, but that wasn’t bringing in enough income to match its need for capital.

For Lynch, the answer was obvious: give more weight to stocks, at the expense of bonds. He explained stocks do better than bonds because as companies grow, they become larger and more profitable. Stockholders share in that new wealth through higher dividends and higher share prices. On the other hand, when you buy a bond, you know the yield is fixed and will not increase, and there will be no capital gain because the principal will not change.

Bonds or bond funds?

Bonds are often touted as safe investment choices, yet that’s not always true. The big threat is inflation, which had robbed retirees of purchasing power in the last third of the 20th century. Even an inflation rate of 2% can significantly reduce a retiree’s purchasing power in the 20 to 30 years after retirement.

Some investors believe it’s safer to buy bonds in a fund, rather than individually. Lynch disagreed, saying, “A bond fund offers no protection against higher interest rates, which is by far the greatest danger in owning a long-term IOU. When rates go higher, a bond fund loses value as quickly as an individual bond with a similar maturity.”

Stocks versus stock funds

From his perspective as a former fund manager, the author noted a stock fund is no different than a stock in one important way: you must keep owning it to benefit. If you don’t have the willpower to stick through market slumps, owning a stock fund is no better than owning stocks. For those who cannot stomach market volatility, he thought balanced funds or asset allocation funds might be appropriate. However, they would have to settle for lesser returns.

Basic types of mutual funds

  1. Capital appreciation funds allow their managers lots of leeway in the types of strategies they employ (Lynch’s Fidelity Magellan Fund was an example).
  2. Value funds invest in undervalued assets, giving them a margin of safety beyond a stock’s intrinsic value.
  3. Quality growth funds, medium and large companies growing at “a respectable and steady rate, and increasing their earnings by 15 percent a year or better.”
  4. Emerging growth funds, which invest in small, fast-growing companies.
  5. Special situation funds that look for companies in which something unique or unusual is occurring or about to occur.

When comparing funds, always be sure to compare individual funds with other funds in that category; for example, don’t compare returns for value funds and emerging growth funds.

Load or no-load funds?

A mutual fund that carries a load is one for which you’re paying sales commissions. According to Lynch (whose fund was a no-load), paying 2% to 5% is OK if you plan to stick with the same fund for at least several years. Further, he noted:

“The ongoing fees and expenses of a fund can certainly hamper its performance, which is where the index funds have the advantage, as we’ve seen. In comparing the past performance of one managed fund against another, you can ignore the fees. A fund’s annual return is calculated after fees and expenses are deducted, so they’re automatically factored into the equation.”

Four more types of funds

Going beyond the basic funds, Lynch wanted to tell investors about four other types:

  1. Sector funds allow investors to buy into one sector, such as financials or oil and gas, a good thing for people who have extensive knowledge about one specific industry.
  2. Convertible funds are a stock-bond hybrid, theoretically providing the best of both worlds: the high performance of stocks and the stability of bonds. In return for accepting lower interest payments, investors gain the right to convert their bonds into stocks. According to Lynch, it’s an area best left to professionals.
  3. Closed-end funds trade like stocks and unlike mutual funds, which are bought and sold after the market closes for the day. Closed-end funds also have a specified number of shares, unlike open-ended funds that create or retire shares when an investor buys or sells.
  4. Country funds allow investors to put their capital into specific countries, just as they invest in specific sectors. When Lynch was writing this in the early 1990s, many foreign economies were growing faster than the domestic, American economy.

Conclusion

Even at the time Peter Lynch wrote “Beating the Street” in the early 1990s, there were already more mutual funds than stocks, making the choice of funds a challenge too. To help with selections, he had several recommendations.

They included putting as much into stock funds (at the expense of bonds and bond funds) as you can; if you have to, buy bonds not bond funds; stock funds are just as volatile as individual stocks; know what types of funds you own and divide your money among them; and be aware of paying commissions or loads when you buy funds.

This book was written before index funds became a force in the investing world, so we don’t have his opinions about them.

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About the author:

Robert Abbott
Robert F. Abbott has been investing his family’s accounts since 1995 and in 2010 added options -- mainly covered calls and collars with long stocks.

He is a freelance writer, and his projects include a website that provides information for new and intermediate-level mutual fund investors (whatisamutualfund.com).

As a writer and publisher, Abbott also explores how the middle class has come to own big business through pension funds and mutual funds, what management guru Peter Drucker called the "unseen revolution."

Visit Robert Abbott's Website


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