PDF Summary:Beating the Street, by Peter Lynch

In Beating the Street, famed mutual fund manager Peter Lynch explores how ordinary investors can outperform the market—and the pricey Wall Street fund managers who assemble stock portfolios—through hard work, diligence, and persistence in picking the right stocks to build a winning portfolio.

In this guide, we’ll explore Lynch’s strategy by which non-professional, individual investors can beat the pros, looking at:

• Why bonds, despite their reputation as a low-risk investment, offer poorer returns than stocks over the long haul
• Why it’s crucial to do your homework and understand everything about the companies you’re investing in
• The importance of being patient, persistent, and willing to endure the inevitable short-term losses that come from investing in the stock market

Throughout the guide, we’ll supplement Lynch’s insights with investment advice and perspectives from other investors and financial experts. We’ll also provide some historical context for Lynch’s ideas and explore how the investment world has changed since the book’s publication in 1993—and how those changes might affect today’s investment strategies.

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For Simons, it wasn’t necessary to know anything substantive about the underlying stocks, bonds, commodities, or currencies being traded or why their prices fluctuated the way they did: What mattered was the integrity of the data and the reliability of the patterns identified by his trading algorithm. If the algorithm could detect a non-random pattern and make bets that paid off more often than not, the fund would invest even if it followed no apparent economic logic.

Understand the Fundamentals

Your job as an investor is to understand the fundamentals behind the companies you invest in, writes Lynch. Picking stocks isn’t supposed to be a game of chance: When you buy a stock, you’re not buying a raffle ticket, hoping that your stock is the “lucky” one that rises in value. Instead, behind every stock is a real company, with managers, employees, products and services, and a business strategy. Your job as an investor is to understand the fundamentals behind the companies you invest in—the products or services they bring to market, their strategy for long-term growth, and their overall financial health. If you’re picking stocks without doing this research, you’re effectively just gambling.

Lynch writes that it’s important to get into the details of a company’s operations before you decide to invest in it. In fact, during his time as a fund manager, Lynch often made a point of visiting the headquarters of companies he was considering adding to the Magellan portfolio and meeting with executives. He wanted to know that a company’s leaders had clear plans for future growth, that a company wasn’t saddled by unsustainable levels of corporate debt, and that the people running the firm were generally competent.

Fundamental vs. Technical Analysis

Lynch’s approach of rigorously analyzing individual companies and stocks speaks to the differences between two schools of investing thought: fundamental analysis and technical analysis.

Fundamental analysis is the more traditional approach, which Lynch advocates. This school of thought attempts to measure the intrinsic value of a stock. Adherents of this philosophy seek to answer why a particular stock goes up or down in value. They do this, as the name suggests, by delving into the “fundamentals” of the company behind the stock. They’ll look at sector-wide trends and the company’s earnings, expenses, assets, and liabilities to make predictions about what the stock will do.

Technical analysis, on the other hand, identifies trends and correlations—how a particular stock goes up or down in value. It’s much closer to what Simons and his colleagues did, as detailed in The Man Who Solved the Market. Technical analysts assume that the “fundamentals” are already factored into the stock price, so it’s a waste of time and effort to analyze them. Instead, they use mathematical analysis to identify patterns and trends within the market and across different types of financial instruments (like stocks, bonds, commodities, and currencies). These trends can signal what a stock will do in the future.

Manage Your Portfolio

Once you’ve figured out which companies’ stock to purchase for your portfolio, Lynch writes that it’s time to turn to how to manage that portfolio. According to Lynch, proper management of your portfolio is key to your success as an investor. He offers some core principles of stock portfolio management:

• Don’t invest in too many companies.
• Pay attention to the companies you invest in.
• Diversify your portfolio.

1) Don’t Invest in Too Many Companies

Crucially, you should never hold more stocks in your portfolio than you can personally manage or keep track of. A manager of a large fund with a staff of analysts can afford to own stock in hundreds or even thousands of companies; however, as a retail investor, you’ll never have the bandwidth to do the research you need to do to make informed investment decisions in a portfolio that large.

What’s the “Right” Number of Stocks to Own?

Although Lynch recommends keeping a small portfolio so you’ll be able to manage and oversee the stocks in it, there are risks to this approach. In a small portfolio, it takes just a few stocks with low returns to drag your entire position down. Similarly, your portfolio can become overly dependent on just a few high performers. For these reasons, some research suggests that the right number of stocks to hold in a well-diversified portfolio is 25 to 30 companies.

In determining how many stocks you should own at once, investment experts also advise that it depends on your stage in life, your investment goals, and your personal risk tolerance. Someone in their 20s may be more comfortable with a relatively small portfolio of only a dozen or so stocks. Although this will likely be a more volatile portfolio because it’s more subject to the ups and downs of just a few companies, at this age you have enough time left before retirement to ride out the short-term fluctuations. Meanwhile, someone nearing retirement may want to hold a larger portfolio of around 30 stocks to reduce the risk of loss if one or two stocks decline.

2) Pay Attention to Your Stocks

Lynch advises you to pay consistent attention to the stocks in your portfolio. Playing the stock market is not a “set it and forget it” business. Analyzing the key metrics of the companies whose shares you own—quarterly earnings statements, profit and loss statements, balance sheets, and cash flow statements—will help you determine which stocks are poised for sustainable long-term growth and which are overvalued and likely to suffer a decline. Don’t just hold onto a stock by inertia: If the fundamentals of the company are truly headed in the wrong direction, it may be time to sell them.

Lynch writes that it’s best to take copious notes on the activities of the companies in your portfolio. He recommends a review of your full portfolio every six months to evaluate which stocks to drop, which new ones to add, and which current ones to buy more of.

(Shortform note: Although Lynch recommends constant vigilance with your portfolio, other investment experts write that this level of oversight may not be sustainable for most individual investors. To have a truly well-diversified portfolio, you’d likely need to own between 20 and 100 stocks. You’d also need to constantly review the financial statements of dozens of companies. This takes more time than most non-professional investors have, not to mention a level of knowledge and expertise to properly interpret that data that many such investors likely won’t have.)

3) Keep Your Portfolio Diversified

Lynch writes that it’s crucial to maintain a balanced portfolio. This means having a mix of stocks from many sectors of the economy. Indeed, warns Lynch, it’s a risky strategy to overload in stocks from companies in any one industry, no matter how stable and secure that sector may seem. Ideally, you want a portfolio whose composition closely reflects the total market—this protects you against a collapse in one industry, because your losses there may be offset by gains (or at least smaller losses) in other industries.

Recent history shows why it would be a gamble to bet too heavily in one industry: Putting all your money into tech stocks would have wiped you out during the dot-com crash of the early 2000s; going all-in on cryptocurrency would have been calamitous in 2022 when cryptocurrencies plummeted amid fraud scandals.

The Risks of Over-Diversification

Although many experts agree with Lynch that it’s wise to maintain a diversified portfolio, there’s also risk in having a portfolio that’s too diversified. Some evidence suggests that the risk-mitigation benefits of a diversified portfolio diminish greatly once you own more than 20 stocks. In other words, there’s only a marginal difference from a diversification standpoint between owning 20 stocks and 10,000.

If you own too many different stocks and become too diversified, you can reduce your potential for high returns. In a portfolio consisting of dozens or even hundreds of stocks, a few stocks performing exceptionally well will have only a middling impact on your returns because they would only represent a small share of your total portfolio. But if you had a diversified portfolio of only around 20 stocks, those high performers would have an outsized positive impact on your returns.

4) Play the Long Game

Lynch writes that successfully managing your portfolio is largely about staying the course in the market. Don’t worry about the short-term ups and downs—the historical performance of the market over decades shows that consistently owning stocks is a winning strategy.

When you start buying stocks, you’ll inevitably experience market downturns. They can last for a month, a quarter, or even a couple of years. These downturns are often unpredictable and are usually caused by large-scale macroeconomic events and conditions that individual investors have zero control over—from interest rate changes, to geopolitical events, to natural forces like weather and pandemics.

And when these bear markets strike, you’re likely to lose money. But, warns Lynch, this isn’t the time to flee the market in a panic. Indeed, he doesn’t think of them as market collapses at all, but rather as market corrections—times when previously overvalued stocks come back to Earth and settle at prices that more accurately reflect their worth. And it’s during these market corrections that savvy investors can seize the opportunity to find bargains and buy stocks at discount prices. By contrast, writes Lynch, bull markets (when stock prices experience a prolonged rise) are often a sign of overpriced stocks, where you’ll be hard-pressed to find good bargains.

Time in the Market, Not Timing the Market

The history of stock prices, as measured by well-regarded indexes like the S&P 500, bears Lynch’s argument out. Many investment experts argue that success is more about time in the market than about timing the market. In other words, continually investing in the stock market is a better strategy for high returns than trying to buy stocks at a low price and sell them at a high price. This is because it’s difficult to predict when the market will go up and down, and as Lynch points out, you as an individual investor have almost no control over it.

But evidence suggests that playing the long game does work. Over the past 94 years, the S&P 500 has swung back and forth, with 27% of those years having negative returns. So if you’re buying and selling stock in a one-year timeframe, you have a significant risk of taking a loss. But the longer the time window of your investment, your chances of positive returns become overwhelmingly likely. Over those same 94 years, through December 31, 2022, 94% of 10-year periods have had positive returns.

Part 3: The Case for Index Funds

We’ve now explored why you should invest in stocks instead of bonds and how you should build and manage your personal stock portfolio. But what if you want to get exposure to the stock market without going through the trouble of researching, building, and managing your own portfolio of individual stocks?

Lynch writes that stock funds can offer a good alternative to constructing and maintaining your own stock portfolio. So what are stock funds and how do they work? A stock fund is a type of investment fund that pools money from multiple investors to invest in a selection of stocks. When you buy shares in a stock fund you don’t actually own the underlying stocks—instead, you own shares of the fund itself. The fund manager is responsible for selecting and maintaining the mix of stocks in the fund, which saves you the time and trouble of having to do this.

But, as we’ve seen, Lynch is skeptical of pricey fund managers, who he argues often charge high fees and deliver returns that don’t even beat the average market returns. That’s why he recommends stock index funds as a particular type of stock fund for investors who want to enjoy solid returns without having to manage their own portfolio—or see their returns eaten up by high management fees.

Index funds are stock funds composed of a broad portfolio of stocks that are designed to mirror one of the big market indexes. Many popular index funds at large investment companies like Vanguard, Fidelity, or State Street offer index funds that track well-known market indexes like the S&P 500 or the Dow Jones Industrial Average.

The stocks in an index-tracking mutual fund are automatically selected based on their position in these indexes. You're not actively managing it, nor is a fund manager. The fund you invest in purchases shares of companies in proportion to those companies’ positions within whichever index the fund’s tracking. For example, if the fund you bought into tracks the S&P 500 and Google stock comprises 3% of the total market capitalization of the S&P 500, your fund will have 3% of its holdings in Google stock.

The Rise—and Risks—of Passive Investing

In the years since Lynch wrote Beating the Street, index funds have risen greatly in popularity. These funds are described as being “passively managed.” They don’t have an active manager like Lynch selecting stocks for inclusion in the portfolio based on their financial performance or projections for future growth. Instead, these passively managed funds buy and sell stocks automatically when those stocks enter or exit indexes like the S&P 500 or the Dow Jones Industrial Average.

And because index funds have become such major purchasers of US stocks, index funds now control 20% to 30% of the US equities market. Despite their popularity, some observers are concerned that the growth of index funds represents a dangerous concentration of economic power.

Today, for nine in 10 companies listed on the S&P 500, their largest single shareholder is one of the “Big Three” money managers—BlackRock, Vanguard, and State Street. And these three firms control 80-90% of the index fund market. With this level of concentration, we could soon be facing an economic future where a small handful of individuals would have vastly disproportionate power over most publicly traded companies.

Different Types of Index Funds for Different Investment Needs

Lynch advises that there are many different types of index funds that track different segments of the financial market, depending on where an investor wants to put her money, such as market cap funds, sector-based funds, and regional funds.

Market Cap Index Funds

These are funds that invest in stocks based on those stocks’ total market capitalization (or “market cap”)—the number of shares currently issued multiplied by the price per share. So, for example, a company with one million shares currently issued trading at $50 per share would have a market cap of $50 million. There are funds that invest in large-cap stocks (those with market caps above $10 billion), mid-cap stocks (with market caps between $2 billion and $10 billion), and small-cap stocks (those with market caps between $250 million and $2 billion).

You’d purchase shares in large-cap index funds if you want the relative stability of investing in mature, well-established companies that are more likely to earn steady returns than small companies or startups. On the other hand, you’d invest in medium- or small-cap index funds if you want the potentially high returns that can come from investing in startups and growing companies—and can stomach the higher volatility and risk that can come with it.

(Shortform note: Although you can invest in mid-cap and small-cap indexes if you want to cover the entire market, you can have most of the total market represented in your portfolio just by investing in large-cap funds. This is because the biggest stocks already account for such a large share of the total market capitalization. The S&P 500 index of large-cap US equities encompasses the top-500 American companies by market capitalization. According to S&P, this represents approximately 80% of the total market capitalization.)

Sector-Based Index Funds

There are also index funds that buy stock in companies exclusively in a specific industry or market. For example, a fund may buy shares of companies in sectors like energy, consumer goods, health care, information technology, or real estate. You’d invest in a sector-based fund if you believe that that sector offers higher potential for growth than other sectors of the economy, or if you want to hedge your portfolio if you’ve invested in other sectors.

For example, let’s say you’ve invested heavily in the traditional energy sector (which includes oil companies, natural gas producers, and coal mine operators). You might then want to purchase shares in a renewable energy index fund (which includes companies engaged in wind, solar, hydroelectric, and even nuclear energy), so you can offset potential losses in case the price of oil drops or if the government passes new regulations that restrict fossil fuel production.

(Shortform note: Sector-based funds do come with their own unique risks. Investing in a sector-based index fund means your returns are closely tied to the performance of a specific industry, even if you’re diversified within that industry. If that sector experiences difficulties or downturns, your portfolio could take a hit. Cyclical effects could also put your portfolio at risk. This is because different sectors of the economy tend to perform differently at various points in the economic cycle. For instance, tech sectors might do well during economic expansions, while utility sectors might perform better during recessions. If you don’t watch these cyclical effects, you could wind up overly invested in a sector on the wrong end of the business cycle.)

Regional Index Funds

There are also index funds that buy shares in companies (often those with the largest market caps across a wide range of industries) that are based in a particular region or country. So, for example, there are funds that trade exclusively in North American, European, Asian, or South American stocks.

You would invest in regional index funds if you believe that a particular region or country’s economy offers the kind of growth you want. If you want more stable, but potentially lower returns, you would perhaps invest in a regional fund that comprises companies from more developed markets, such as North America or Western Europe. If you’re looking for potentially high returns (and can handle higher risk), you might invest in regional index funds composed of stocks from companies in developing parts of the world—such as sub-Saharan Africa or Southeast Asia.

(Shortform note: When you invest in region- or country-specific index funds, it’s important to understand country risk. Country risk is the risk of investing in a particular country. The risk can come from factors including but not limited to political instability, natural disasters, and unfavorable exchange rates. There are several resources available to assess country risk, including information published by the Organisation for Economic Co-Operation and Development (OECD). In addition, the major credit rating agencies—Standard & Poor's (S&P), Moody's, and Fitch—each have country-by-country analyses of economic fundamentals such as political stability, the rule of law, and fiscal and monetary flexibility.)