Peter Lynch is one of the all-time greats. While running the Fidelity Magellan fund from 1977 to his retirement in 1990, he generated almost hard-to-believe annualized returns of 29.2% per year. And take note that this was before the roaring bull market of the 1990s. If there were a pantheon of investing gods, no one would question Peter Lynch’s place in it.
But Lynch was also responsible for some of the most misunderstood and poorly-used words of investment advice in history when he recommended that you “invest in what you know.”
Lynch’s advice here is actually pretty solid if used right. Wall Street analysts and fund managers often never leave their elegant New York offices. Regular, everyday investors can often see a budding trend years before Wall Street simply by virtue of having boots on the ground. And new trends in consumer goods are often visible on the street months or years before they show up in the financial statements. Lynch routinely wrote over the years that he found some of his best investment ideas from trips to the mall.
But this is where good advice can go very wrong. “Buying what you know” can very quickly degenerate into buying a stock because you like its product—what I call the “Peter Lynch Bias.”
Liking the taste of their burritos is not a sufficient reason for buying shares of Chipotle Mexican Grill, Inc. (NYSE:CMG) any more than liking their lattes is reason to buy shares of Starbucks. Peter Lynch was never that simplistic, and we shouldn’t be either.
On a related note, we need to look past the hokiness of another legendary investor, Warren Buffett. Buffett likes to play the part of a simple Midwesterner –the kind of guy that really would buy Coca-Cola Co (stock because he likes the taste of Cherry Coke. Don’t believe it for a second. It’s an act. Buffett is one of the sharpest financial minds in history, and he didn’t build Berkshire Hathaway into a financial empire with such sentimental nonsense. He did it by having discipline and buying the shares of great businesses when they were reasonably priced.
So, how can we avoid the Peter Lynch Bias?
Simple: By staying emotionally detached, having a process in place and sticking to it.
By all means, follow Lynch’s advice by looking for emerging trends on your next trip to the mall. But before you pull the trigger to buy or sell something, make sure you’re following your process.
Here are a few practical suggestions on avoiding the Peter Lynch Bias:
If you’re looking to “invest in what you know” with respect to a product you like, try using one of their competitors before seriously considering purchasing the stock. Years ago, if I had really taken the time to learn how to use an Apple Inc (NASDAQ:AAPL) iPhone, I probably wouldn’t have gotten sucked into the BlackBerry Ltd (NASDAQ:BBRY) (Back then, Research in Motion) value trap. Yes, it was one of the cheapest stock in the world when I recommended it last year. But I cannot deny that my decision to recommend it was biased by my ownership of a BlackBerry phone.
To the best extent you can, try to follow trading rules and use stop losses. What works for one investor will be very different than what works for another. Perhaps you use a hard stop loss of, say, 10% below your purchase price. Or perhaps you use a trailing stop or 20-25%. If you are a value investor, perhaps you base your sell decision on valuation or fundamentals rather than market price. But in any event, my point stands. Lay out the conditions under which you intend to sell and stick to them. Stock ownership is a marriage of convenience with quick, no-fault divorce if your situation changes. Don’t make the mistake of falling in love.
Unleash your inner Spock. For readers who are not Star Trek fans, Spock is an alien from the planet Vulcan who has completely supressed his emotions. If talking about a stock or watching its price fluctuate gets your heart racing, take a step back and try to look at the investment through Spock’s eyes. Is it logical? Do the numbers make sense? Are the growth projections based on reasonable facts or on optimistic hope? Would you buy a different company if it were trading at the same price multiple?
One size does not fit all here. But whatever investment discipline you follow, don’t allow your enthusiasm for a product to cloud your judgment.