One Up on Wall Street: How to Use What You Already Know to Make Money In

by Peter Lynch

  It’s one thing to prefer stocks to a stodgy savings account that yields 5 percent forever, and quite another to prefer them to a money-market that offers the best short-term rates, and where the yields rise right away if the prevailing interest rates go higher.

  If your money has stayed in a money-market fund since 1978, you certainly have no reason to feel embarrassed about it. You’ve missed a couple of major stock market declines. The worst you’ve ever collected is 6 percent interest, and you’ve never lost a penny of your principal. The year that short-term interest rates rose to 17 percent (1981) and the stock market dropped 5 percent, you made a 22 percent relative gain by staying in cash.

  During the stock market’s incredible surge from Dow 1775 on September 29, 1986, to Dow 2722 on August 25, 1987, let’s say you never bought a single stock, and you felt dumber and dumber for having missed this once-in-a-lifetime opportunity. After a while you wouldn’t even tell your friends you had all your money in a money-market—admitting to shoplifting would have been less mortifying.

  But the morning after the crash, with the Dow beaten back to 1738, you felt vindicated. You avoided the whole trauma of October 19. With stock prices so drastically reduced, the money-market actually had outperformed the stock market over the entire year—6.12 percent for the money-market to 5.25 percent for the S&P 500.

  THE STOCKS REBUT

  But two months later the stock market had rebounded, and once again stocks were outperforming both money-market funds and long-term bonds. Over the long haul they always do. Historically, investing in stocks is undeniably more profitable than investing in debt. In fact, since 1927, common stocks have recorded gains of 9.8 percent a year on average, as compared to 5 percent for corporate bonds, 4.4 percent for government bonds, and 3.4 percent for Treasury bills.

  The long-term inflation rate, as measured by the Consumer Price Index, is 3 percent a year, which gives common stocks a real return of 6.8 percent a year. The real return on Treasury bills, known as the most conservative and sensible of all places to put money, has been nil. That’s right. Zippo.

  The advantage of a 9.8 percent return from stocks over a 5 percent return from bonds may sound piddling to some, but consider this financial fable. If at the end of 1927 a modern Rip Van Winkle had gone to sleep for 60 years on $20,000 worth of corporate bonds, paying 5 percent compounded, he would have awakened with $373,584—enough for him to afford a nice condo, a Volvo, and a haircut; whereas if he’d invested in stocks, which returned 9.8 percent a year, he’d have $5,459,720. (Since Rip was asleep, neither the Crash of ’29 nor the ripple of ’87 would have scared him out of the market.)

  In 1927, if you had put $1,000 in each of the four investments listed below, and the money had compounded tax-free, then 60 years later you’d have had these amounts:

  In spite of crashes, depressions, wars, recessions, ten different presidential administrations, and numerous changes in skirt lengths, stocks in general have paid off fifteen times as well as corporate bonds, and well over thirty times better than Treasury bills!

  There’s a logical explanation for this. In stocks you’ve got the company’s growth on your side. You’re a partner in a prosperous and expanding business. In bonds, you’re nothing more than the nearest source of spare change. When you lend money to somebody, the best you can hope for is to get it back, plus interest.

  Think of the people who’ve owned McDonald’s bonds over the years. The relationship between them and McDonald’s begins and ends with the payoff of the debt, and that’s not the exciting part of McDonald’s. Sure, the original bondholders have gotten their money back, the same as they would have with a bank CD, but the original stockholders have gotten rich. They own the company. You’ll never get a tenbagger in a bond—unless you’re a debt sleuth who specializes in bonds in default.

  WHAT ABOUT THE RISKS?

  “Ah, yes,” you say to yourself, especially after the latest drop in stock prices, “but what about the risks? Aren’t stocks riskier than bonds?” Of course stocks are risky. Nowhere is it written that a stock owes us anything, as it’s been proven to me on hundreds of sorry occasions.

  Even blue-chip stocks held long term, supposedly the safest of all propositions, can be risky. RCA was a famous prudent investment, and suitable for widows and orphans, yet it was bought out by GE in 1986 for $66.50 a share, about the same price that it traded in 1967, and only 74 percent above its 1929 high of $38.25 (adjusted for splits). Less than one percent worth of annual appreciation is all you got in 57 years of sticking with a solid, world-famous, and successful company. Bethlehem Steel continues to sell far below its high of $60 a share reached in 1958.

  Glance at a list of the original Dow Jones industrials from 1896. Who’s ever heard of American Cotton Oil, Distilling and Cattle Feeding, Laclede Gas, U.S. Leather Preferred? These once-famous stocks must have vanished long ago.

  Then from the 1916 list we see Baldwin Locomotive, gone by 1924; the 1925 list includes such household names as Paramount Famous Lasky and Remington Typewriter; in 1927, Remington Typewriter disappears and United Drug takes its place. In 1928, when the Dow Jones was expanded from 20 to 30 companies, the new arrivals included Nash Motors, Postum, Wright Aeronautical, and Victor Talking Machine. The latter two companies were removed by 1929—Victor Talking Machine because it had merged into RCA. (You’ve seen the results of sticking with that one.) In 1950, we find Corn Products Refining on the list, but by 1959 it, too, is taken off and replaced by Swift and Co.

  The point is that fortunes change, there’s no assurance that major companies won’t become minor, and there’s no such thing as a can’t-miss blue chip.

  Buy the right stocks at the wrong price at the wrong time and you’ll suffer great losses. Look what happened in the 1972–74 market break, when conservative issues such as Bristol-Myers fell from $9 to $4, Teledyne from $11 to $3, and McDonald’s from $15 to $4. These aren’t exactly fly-by-night companies. Buy the wrong stocks at the right time and you’ll suffer more of the same. During certain periods it seems to take forever for the theoretical 9.8 percent annual gain from stocks to show up in practice. The Dow Jones industrials reached an all-time high of 995.15 in 1966 and bounced along below that point until 1972. In turn, the high of 1972–73 wasn’t exceeded until 1982.

  But with the possible exception of the very short-term bonds and bond funds, bonds can be risky, too. Here, rising interest rates will force you to accept one of two unpleasant choices: suffer with the low yield until the bonds mature, or sell the bonds at a substantial discount to face value. If you are truly risk-averse, then the money-market fund or the bank is the place for you. Otherwise, there are risks wherever you turn.

  Municipal bonds are thought to be as secure as cash in a strongbox, but on the rare occasion of a default, don’t tell the losers that bonds are safe. (The best-known default is that of the Washington Public Power Supply System, and their infamous “Whoops” bonds.) Yes, I know bonds pay off in 99.9 percent of the cases, but there are other ways to lose money on bonds besides a default. Try holding on to a 30-year bond with a 6 percent coupon during a period of raging inflation, and see what happens to the value of the bond.

  A lot of people have invested in funds that buy Government National Mortgage Association bonds (Ginnie Maes) without realizing how volatile the bond market has become. They are reassured by the ads—“100 percent government-guaranteed”—and they’re right, the interest will be paid. But that doesn’t protect the value of their shares in the bond fund when interest rates rise and the bond market collapses. Open the business page and look at what happens to such funds on a day that interest rates rise half a percent and you’ll see what I mean. These days, bond funds fluctuate just as wildly as stock funds. The same volatility in interest rates that enables clever investors to make big profits from bonds also makes holding bonds more of a gamble.

  STOCKS AND STUD POKER

  Frankly, there is no way to separate investing from gambling into tho
se neat categories that are meant to reassure us. There’s simply no Chinese wall, bundling board, or any other absolute division between safe and rash places to store money. It was in the late 1920s that common stocks finally reached the status of “prudent investments,” whereas previously they were dismissed as barroom wagers—and this was precisely the moment at which the overvalued market made buying stocks more wager than investment.

  For two decades after the Crash, stocks were regarded as gambling by a majority of the population, and this impression wasn’t fully revised until the late 1960s when stocks once again were embraced as investments, but in an overvalued market that made most stocks very risky. Historically, stocks are embraced as investments or dismissed as gambles in routine and circular fashion, and usually at the wrong times. Stocks are most likely to be accepted as prudent at the moment they’re not.

  For years, stocks in large companies were considered “investments” and stocks in small companies “speculations,” but lately small stocks have become investments and the speculating is done in futures and options. We’re forever redrawing this line.

  I’m always amused when people describe their investments as “conservative speculations” or else claim that they are “prudently speculating.” Usually that means they hope they’re investing but they’re worried that they’re gambling. The phrase “we’re seeing one another” serves the same function for couples who can’t decide if they’re serious.

  Once the unsettling fact of the risk in money is accepted, we can begin to separate gambling from investing not by the type of activity (buying bonds, buying stocks, betting on the horses, etc.) but by the skill, dedication, and enterprise of the participant. To a veteran handicapper with the discipline to stick to a system, betting on horses offers a relatively secure long-term return, which to him has been as reliable as owning a mutual fund, or shares in General Electric. Meanwhile, to the rash and impetuous stockpicker who chases hot tips and rushes in and out of his equities, an “investment” in stocks is no more reliable than throwing away paychecks on the horse with the prettiest mane, or the jockey with the purple silks.

  (In fact, to the rash and impetuous stock player, my advice is: Forget Wall Street and take your mad money to Hialeah, Monte Carlo, Saratoga, Nassau, Santa Anita, or Baden-Baden. At least in those pleasant surroundings, when you lose, you’ll be able to say you had a great time doing it. If you lose on stocks, there’s no consolation in watching your broker pace around the office.

  Also, when you lose mad money at the horses you simply throw your worthless tickets on the floor and you’re done with it, but in stocks, options, and so forth you have to relive the painful episodes with the tax accountant every spring. It may take days of extra work to figure all this out.)

  To me, an investment is simply a gamble in which you’ve managed to tilt the odds in your favor. It doesn’t matter whether it’s Atlantic City or the S&P 500 or the bond market. In fact, the stock market most reminds me of a stud poker game.

  Betting on seven-card stud can provide a very consistent long-term return to people who know how to manage their cards. Four of the cards are dealt faceup, and you can not only see all of your hand but most of your opponents’ hands. After the third or fourth card is dealt, it’s pretty obvious who is likely to win and who is likely to lose, or else it’s obvious there is no likely winner. It’s the same on Wall Street. There’s a lot of information in the open hands, if you know where to look for it.

  By asking some basic questions about companies, you can learn which are likely to grow and prosper, which are unlikely to grow and prosper, and which are entirely mysterious. You can never be certain what will happen, but each new occurrence—a jump in earnings, the sale of an unprofitable subsidiary, the expansion into new markets—is like turning up another card. As long as the cards suggest favorable odds of success, you stay in the hand.

  Anyone who plays regularly in a monthly stud poker game soon realizes that the same “lucky stiffs” always come out ahead. These are the players who undertake to maximize their return on investment by carefully calculating and recalculating their chances as the hand unfolds. Consistent winners raise their bet as their position strengthens, and they exit the game when the odds are against them, while consistent losers hang on to the bitter end of every expensive pot, hoping for miracles and enjoying the thrill of defeat. In stud poker and on Wall Street, miracles happen just often enough to keep the losers losing.

  Consistent winners also resign themselves to the fact that they’ll occasionally be dealt three aces and bet the limit, only to lose to a hidden royal flush. They accept their fate and go on to the next hand, confident that their basic method will reward them over time. People who succeed in the stock market also accept periodic losses, setbacks, and unexpected occurrences. Calamitous drops do not scare them out of the game. If they’ve done the proper homework on H & R Block and bought the stock, and suddenly the government simplifies the tax code (an unlikely prospect, granted) and Block’s business deteriorates, they accept the bad break and start looking for the next stock. They realize the stock market is not pure science, and not like chess, where the superior position always wins. If seven out of ten of my stocks perform as expected, then I’m delighted. If six out of ten of my stocks perform as expected, then I’m thankful. Six out of ten is all it takes to produce an enviable record on Wall Street.

  Over time, the risks in the stock market can be reduced by proper play just as the risks in stud poker are reduced. With improper play (buying a stock that’s overpriced) even the purchase of Bristol-Myers or Heinz can result in huge losses and wasted opportunities, as I’ve said. It happens to people who imagine that betting with blue chips relieves them of the need to pay attention, so they lose half their money in quick fashion and may not recoup it for another eight years. In the early 1970s millions of uninformed dollars chased overpriced opportunities and soon disappeared as a result. Does that make Bristol-Myers and McDonald’s risky investments? Only because of the way people invested in them.

  On the other hand, assuming you’d done the homework, putting your money on the risky and troubled General Public Utilities, the owners of the Three Mile Island nuclear problem, was far more “conservative” than an ill-timed investment in solid old Kellogg.

  Not wanting to “risk” investment capital that belonged to my mother-in-law, Mrs. Charles Hoff, I once advised her to buy stock in Houston Industries, a very “safe” company. It was safe all right—the stock did nothing for more than a decade. I figured I could take more of a “gamble” with my own mother’s money, so I bought her the “riskier” Consolidated Edison. It went up sixfold. Con Ed wasn’t all that risky to those who had continued to monitor the fundamentals. The big winners come from the so-called high-risk categories, but the risks have more to do with the investors than with the categories.

  The greatest advantage to investing in stocks, to one who accepts the uncertainties, is the extraordinary reward for being right. This is borne out in the mutual fund returns calculated by the Johnson Chart Service of Buffalo, New York. There’s a very interesting correlation here: the “riskier” the fund, the better the payoff. If you’d put $10,000 into the average bond fund in 1963, fifteen years later you’d come out with $31,338. The same $10,000 in a balanced fund (stocks and bonds) would have produced $44,343; in a growth and income fund (all stocks), $53,157; and in an aggressive growth fund (also all stocks), $76,556.

  Clearly the stock market has been a gamble worth taking—as long as you know how to play the game. And as long as you own stocks, new cards keep turning up. Now that I think of it, investing in stocks isn’t really like playing a seven-card stud-poker hand. It’s more like playing a 70-card stud-poker hand, or if you own ten stocks, it’s like playing ten 70-card hands at once.

  4

  Passing the Mirror Test

  “Is General Electric a good investment?” isn’t the first thing I’d inquire about a stock. Even if General Electric is a good in
vestment, it still doesn’t mean you ought to own it. There’s no point in studying the financial section until you’ve looked into the nearest mirror. Before you buy a share of anything, there are three personal issues that ought to be addressed: (1) Do I own a house? (2) Do I need the money? and (3) Do I have the personal qualities that will bring me success in stocks? Whether stocks make good or bad investments depends more on your responses to these three questions than on anything you’ll read in The Wall Street Journal.

  (1) DO I OWN A HOUSE?

  As they might say on Wall Street, “A house, what a deal!” Before you do invest anything in stocks, you ought to consider buying a house, since a house, after all, is the one good investment that almost everyone manages to make. I’m sure there are exceptions, such as houses built over sinkholes and houses in fancy neighborhoods that take a dive, but in 99 cases out of 100, a house will be a money-maker.

  How many times have you heard a friend or an acquaintance lament: “I’m a lousy investor in my house”? I’d bet it’s not often. Millions of real estate amateurs have invested brilliantly in their houses. There are sometimes families that must move quickly and are forced to sell at a loss, but it’s the rare individual who manages to lose money on a string of residences one after another, the way it routinely happens with stocks. It’s a rarer individual yet who gets wiped out on a house, waking up one morning to discover that the premises have declared bankruptcy or turned belly up, which is the sad fate of many equities.