ETF Investing Guide: Was Peter Lynch Really Right?

Maximizing your gross return, for most people, means investing in stocks that do well, and preferably beating the market. Most of us think we’re good stock pickers, because we tend to remember (and talk about) our successes.

Well, here are two pieces of bad news. First, in aggregate we can’t all beat the market, because in aggregate we are the market. Second, in my 4 years as a sell-side research analyst, I saw that the only people who consistently beat the market are those with a clear informational or analytical advantage over most other investors. Successful money managers get an “edge” with thorough research and analysis, leading to non-consensus viewpoints that turn out to be correct.

The “non-consensus” part is important. You can be right that a company will do well, but if that’s what everyone else also expects it’s probably priced into the stock already. Yet most individual investors aren’t even aware of what the consensus view reflected in the price of a stock is, and many individuals buy stocks because of something they have read - which means that other people have also read the same thing, which means that the factors that led you to buy the stock are probably already priced in… And most individual investors certainly don’t have an alternate view based on proprietary information, nor the time to do enough research to get an edge over other investors.

Peter Lynch, former manager of the Fidelity Magellan Fund, suggested in his book One Up On Wall Street that individuals could be great investors if they used the information in their everyday lives - the non-insider information at work, the products they saw selling well at the mall - to pick stocks. So perhaps you’re thinking you indeed have an “edge” because of your job, such as knowledge of a particular area of technology.

But there are problems with this. To start with, the value of your expertise might be lower than you realize.

My favorite illustration of the need for skepticism about “expertise” is the Red Herring Portfolio. The Red Herring, the leading magazine about venture capital and venture capitalists that has since closed down, prided itself on knowledge of emerging technologies. Every issue, The Red Herring published a “technology brief”, including snapshots of private and public companies in that area. You’d have thought that The Red Herring Portfolio, a basket of about 15 stocks picked by the magazine and updated monthly, would do extremely well, given the magazine’s focus and expertise in technology.

Well, the Red Herring Portfolio did so badly that the magazine shut down the column in 2002, months before the magazine itself went out of business. To make matters worse, the portfolio performance numbers published by the magazine didn’t include trading costs or capital gains taxes, which would have been crippling as the portfolio changed positions monthly right through the “bubble” and then continued to do so in the subsequent crash.

But as well as questioning the true competitive value of the information you have from your job, here's a more serious risk. If you buy stocks based on the expertise you have from your job, you’ll unnecessarily increase your financial risk.

Here’s what I mean. You’re already highly exposed to your job. After all, it’s your job that pays your salary and probably your retirement contributions and health insurance. The last thing you want to do is to increase your financial exposure to the industry you work in by buying the stocks of your company, its competitors, suppliers and customers.

I saw this clearly in my job as a research analyst covering the communications equipment sector during the boom and bust of 1998 to 2002. Many of my industry contacts were intelligent and sophisticated people who saw that demand for their firms' products was strong, and in some cases realized that their own company (or a competitor) was gaining market share. So they bought stocks in their own sector. Then, when the market for communications equipment subsequently collapsed (to the surprise of most people in the industry), many of them lost not only their jobs, retirement contributions, health insurance and other benefits, but also took a severe hit to their investment portfolios. Their savings took a hit at the time they needed them most.

So in theory, instead of buying stocks based on your work knowledge, what you actually want to do is to hedge your exposure to the industry you work in. You want to ensure that your 401K is not filled with your own company's stock.

Theoretically, you should buy put options or sell short stocks in your sector, particularly your own company’s, to hedge your financial exposure to your job. I say "theoretically" because in practice options trading and short-selling are highly risky (you can easily lose 100% of your money on options and more than 100% selling short), and if you short your own company's stock you could get into legal problems.

But the point is clear. The information you have from your profession or job doesn't give you a stock-picking advantage, because you shouldn't own stocks in your own sector.

ETF Investing Guide Main Page
Previous: The Three Goals of Investing
Next: Your Stock Picks Aren't As Good As They Seem

Comments

[Adrian Scott]

I agree that it's questionable to invest in a magazine's portfolio.

However, when it comes to the original Red Herring, I think we'd be remiss in not giving credit to co-founder Tony Perkins for his co-authorship of "The Internet Bubble", which predicted the bubble, shortly before it burst. Readers could have made a lot of cheddar with that red herring.

[DavidJackson]

Adrian, that's a great point. Tony Perkins is a class-act. I don't think the portfolio was done by him.