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

by Peter Lynch

It’s no accident that people who are geniuses in their houses are idiots in their stocks. A house is entirely rigged in the homeowner’s favor. The banks let you acquire it for 20 percent down and in some cases less, giving you the remarkable power of leverage. (True, you can buy stocks with 50 percent cash down, which is known in the trade as “buying on margin,” but every time a stock bought on margin drops in price, you have to put up more cash. That doesn’t happen with a house. You never have to put up more cash if the market value goes down, even if the house is located in the depressed oil patch. The real estate agent never calls at midnight to announce: “You’ll have to come up with twenty thousand dollars by eleven A.M. tomorrow or else sell off two bedrooms,” which frequently happens to stockholders forced to sell their shares bought on margin. This is another great advantage to owning a house.)

  Because of leverage, if you buy a $100,000 house for 20 percent down and the value of the house increases by five percent a year, you are making a 25 percent return on your down payment, and the interest on the loan is tax-deductible. Do that well in the stock market and eventually you’d be worth more than Boone Pickens.

  As a bonus you get a federal tax deduction on the local real estate tax on the house, plus the house is a perfect hedge against inflation and a great place to hide out during a recession, not to mention the roof over your head. Then at the end, if you decide to cash in your house, you can roll the proceeds into a fancier house to avoid paying taxes on your profit.

  The customary progression in houses is as follows: You buy a small house (a starter house), then a medium-sized house, then a larger house that eventually you don’t need. After the children have moved away, then you sell the big house and revert to a smaller house, making a sizable profit in the transition. This windfall isn’t taxed, because the government in its compassion gives you a once-in-a-lifetime house windfall exemption. That never happens in stocks, which are taxed as frequently and as heavily as possible.

  You can have a forty-year run in houses without paying taxes, culminating in the sweetheart exclusion. Or if there are any taxes to be paid, by now you are in a lower tax bracket, so they won’t be so bad.

  The old Wall Street adage “Never invest in anything that eats or needs repairs” may apply to racehorses, but it’s malarkey when it comes to houses.

  There are important secondary reasons you’ll do better in houses than in stocks. It’s not likely you’ll get scared out of your house by reading a headline in the Sunday real estate section: “Home Prices Take Dive.” They don’t publish the Friday afternoon closing market price of your home address in the classifieds, nor do they run it across the ticker tape at the bottom of your TV, and newscasters do not come on with lists of the ten most active houses—“100 Orchard Lane is down ten percent today. Neighbors saw nothing unusual to account for this unexpected decline.”

  Houses, like stocks, are most likely to be profitable when they’re held for a long period of time. Unlike stocks, houses are likely to be owned by the same person for a number of years—seven, I think, is the average. Compare this to the 87 percent of all the stocks on the New York Stock Exchange that change hands every year. People get much more comfortable in their houses than they do in their stocks. It takes a moving van to get out of a house, and only a phone call to get out of a stock.

  Finally, you’re a good investor in houses because you know how to poke around from the attic to the basement and ask the right questions. The skill of poking around houses is handed down. You grow up watching how your parents checked into the public services, the schools, the drainage, the septic perk test, and the taxes. You remember rules such as “Don’t buy the highest-priced property on the block.” You can spot neighborhoods on the way up and neighborhoods on the way down. You can drive through an area and see what’s being fixed up, what’s run-down, how many houses are left to renovate. Then, before you make an offer on a house, you hire experts to search for termites, roof leaks, dry rot, rusty pipes, faulty wiring, and cracks in the foundation.

  No wonder people make money in the real estate market and lose money in the stock market. They spend months choosing their houses, and minutes choosing their stocks. In fact, they spend more time shopping for a good microwave oven than shopping for a good investment.

  (2) DO I NEED THE MONEY?

  This brings us to question two. It makes sense to review the family budget before you buy stocks. For instance, if you’re going to have to pay for a child’s college education in two or three years, don’t put that money into stocks. Maybe you’re a widow (there are always a few widows in these stock market books) and your son Dexter, now a sophomore in high school, has a chance to get into Harvard—but not on a scholarship. Since you can scarcely afford the tuition as it is, you’re tempted to increase your net worth with conservative blue-chip stocks.

  In this instance, even buying blue-chip stocks would be too risky to consider. Absent a lot of surprises, stocks are relatively predictable over ten to twenty years. As to whether they’re going to be higher or lower in two or three years, you might as well flip a coin to decide. Blue chips can fall down and stay down over a three-year period or even a five-year period, so if the market hits a banana peel, then Dexter’s going to night school.

  Maybe you’re an older person who needs to live off a fixed income, or a younger person who can’t stand working and wants to live off a fixed income from the family inheritance. Either way, you should stay out of the stock market. There are all kinds of complicated formulas for figuring out what percentage of your assets should be put into stocks, but I have a simple one, and it’s the same for Wall Street as it is for the racetrack. Only invest what you could afford to lose without that loss having any effect on your daily life in the foreseeable future.

  (3) DO I HAVE THE PERSONAL QUALITIES IT TAKES TO SUCCEED?

  This is the most important question of all. It seems to me the list of qualities ought to include patience, self-reliance, common sense, a tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit to mistakes, and the ability to ignore general panic. In terms of IQ, probably the best investors fall somewhere above the bottom ten percent but also below the top three percent. The true geniuses, it seems to me, get too enamored of theoretical cogitations and are forever betrayed by the actual behavior of stocks, which is more simple-minded than they can imagine.

  It’s also important to be able to make decisions without complete or perfect information. Things are almost never clear on Wall Street, or when they are, then it’s too late to profit from them. The scientific mind that needs to know all the data will be thwarted here.

  And finally, it’s crucial to be able to resist your human nature and your “gut feelings.” It’s the rare investor who doesn’t secretly harbor the conviction that he or she has a knack for divining stock prices or gold prices or interest rates, in spite of the fact that most of us have been proven wrong again and again. It’s uncanny how often people feel most strongly that stocks are going to go up or the economy is going to improve just when the opposite occurs. This is borne out by the popular investment-advisory newsletter services, which themselves tend to turn bullish and bearish at inopportune moments.

  According to information published by Investor’s Intelligence, which tracks investor sentiment via the newsletters, at the end of 1972, when stocks were about to tumble, optimism was at an all-time high, with only 15 percent of the advisors bearish. At the beginning of the stock market rebound in 1974, investor sentiment was at an all-time low, with 65 percent of the advisors fearing the worst was yet to come. Before the market turned downward in 1977, once again the newsletter writers were optimistic, with only 10 percent bears. At the start of the 1982 sendoff into a great bull market, 55 percent of the advisors were bears, and just prior to the big gulp of October 19, 1987, 80 percent of the advisors were bulls again.

  The problem isn’t that investors
and their advisors are chronically stupid or unperceptive. It’s that by the time the signal is received, the message may already have changed. When enough positive general financial news filters down so that the majority of investors feel truly confident in the short-term prospects, the economy is soon to get hammered.

  What else explains the fact that large numbers of investors (including CEOs and sophisticated business people) have been most afraid of stocks during the precise periods when stocks have done their best (i.e., from the mid-1930s to the late 1960s) while being least afraid precisely when stocks have done their worst (i.e., early 1970s and recently in the fall of 1987). Does the success of Ravi Batra’s book The Great Depression of 1990 almost guarantee a great national prosperity?

  It’s amazing how quickly investor sentiment can be reversed, even when reality hasn’t changed. A week or two before the Big Burp of October, business travelers were driving through Atlanta, Orlando, or Chicago, admiring the new construction and remarking to each other, “Wow. What a glorious boom.” A few days later, I’m sure those same travelers were looking at those same buildings and saying: “Boy, this place has problems. How are they ever going to sell all those condos and rent all that office space?”

  Things inside humans make them terrible stock market timers. The unwary investor continually passes in and out of three emotional states: concern, complacency, and capitulation. He’s concerned after the market has dropped or the economy has seemed to falter, which keeps him from buying good companies at bargain prices. Then after he buys at higher prices, he gets complacent because his stocks are going up. This is precisely the time he ought to be concerned enough to check the fundamentals, but he isn’t. Then finally, when his stocks fall on hard times and the prices fall to below what he paid, he capitulates and sells in a snit.

  Some have fancied themselves “long-term investors,” but only until the next big drop (or tiny gain), at which point they quickly become short-term investors and sell out for huge losses or the occasional minuscule profit. It’s easy to panic in this volatile business. Since I’ve run Magellan, the fund has declined from 10 to 35 percent during eight bearish episodes, and in 1987 alone the fund was up 40 percent in August, down 11 percent by December. We finished the year with a 1 percent gain, thus barely preserving my record of never having had a down year—knock on wood. Recently I read that the price of an average stock fluctuates 50 percent in an average year. If that’s true, and apparently it’s been true throughout this century, then any share currently selling for $50 is likely to hit $60 and/or fall to $40 sometime in the next twelve months. In other words, the high for the year ($60) is 50 percent higher than the low ($40). If you’re the kind of buyer who can’t resist getting in at $50, buying more at $60 (“See, I was right, that sucker is going up”), and then selling out in despair at $40 (“I guess I was wrong. That sucker’s going down”) then no shelf of how-to books is going to help you.

  Some have fancied themselves contrarians, believing that they can profit by zigging when the rest of the world is zagging, but it didn’t occur to them to become contrarian until that idea had already gotten so popular that contrarianism became the accepted view. The true contrarian is not the investor who takes the opposite side of a popular hot issue (i.e., shorting a stock that everyone else is buying). The true contrarian waits for things to cool down and buys stocks that nobody cares about, and especially those that make Wall Street yawn.

  When E.F. Hutton talks, everybody is supposed to be listening, but that’s just the problem. Everybody ought to be trying to fall asleep. When it comes to predicting the market, the important skill here is not listening, it’s snoring. The trick is not to learn to trust your gut feelings, but rather to discipline yourself to ignore them. Stand by your stocks as long as the fundamental story of the company hasn’t changed.

  If not, your only hope for increasing your net worth may be to adopt J. Paul Getty’s surefire formula for financial success: “Rise early, work hard, strike oil.”

  5

  Is This a Good Market? Please Don’t Ask

  During every question-and-answer period after I give a speech, somebody stands up and asks me if we’re in a good market or a bad market. For every person who wonders if Goodyear Tire is a solid company, or well-priced at current levels, four other people want to know if the bull is alive and kicking, or if the bear has shown its grizzly face. I always tell them the only thing I know about predicting markets is that every time I get promoted, the market goes down. As soon as those words are launched from my lips, somebody else stands up and asks me when I’m due for another promotion.

  Obviously you don’t have to be able to predict the stock market to make money in stocks, or else I wouldn’t have made any money. I’ve sat right here at my Quotron through some of the most terrible drops, and I couldn’t have figured them out beforehand if my life had depended on it. In the middle of the summer of 1987, I didn’t warn anybody, and least of all myself, about the imminent 1,000-point decline.

  I wasn’t the only one who failed to issue a warning. In fact, if ignorance loves company, then I was very comfortably surrounded by a large and impressive mob of famous seers, prognosticators, and other experts who failed to see it, too. “If you must forecast,” an intelligent forecaster once said, “forecast often.”

  Nobody called to inform me of an immediate collapse in October, and if all the people who claimed to have predicted it beforehand had sold out their shares, then the market would have dropped the 1,000 points much earlier due to these great crowds of informed sellers.

  Every year I talk to the executives of a thousand companies, and I can’t avoid hearing from the various gold bugs, interest-rate disciples, Federal Reserve watchers, and fiscal mystics quoted in the newspapers. Thousands of experts study overbought indicators, oversold indicators, head-and-shoulder patterns, put-call ratios, the Fed’s policy on money supply, foreign investment, the movement of the constellations through the heavens, and the moss on oak trees, and they can’t predict markets with any useful consistency, any more than the gizzard squeezers could tell the Roman emperors when the Huns would attack.

  Nobody sent up any warning flares before the 1973–74 stock market debacle, either. Back in graduate school I learned the market goes up 9 percent a year, and since then it’s never gone up 9 percent in a year, and I’ve yet to find a reliable source to inform me how much it will go up, or simply whether it will go up or down. All the major advances and declines have been surprises to me.

  Since the stock market is in some way related to the general economy, one way that people try to outguess the market is to predict inflation and recessions, booms and busts, and the direction of interest rates. True, there is a wonderful correlation between interest rates and the stock market, but who can foretell interest rates with any bankable regularity? There are 60,000 economists in the U.S., many of them employed full-time trying to forecast recessions and interest rates, and if they could do it successfully twice in a row, they’d all be millionaires by now.

  They’d have retired to Bimini where they could drink rum and fish for marlin. But as far as I know, most of them are still gainfully employed, which ought to tell us something. As some perceptive person once said, if all the economists of the world were laid end to end, it wouldn’t be a bad thing.

  Well, maybe not all economists. Certainly not the ones who are reading this book, and especially not the ones like Ed Hyman at C. J. Lawrence who looks at scrap prices, inventories, and railroad car deliveries, totally ignoring Laffer curves and phases of the moon. Practical economists are economists after my own heart.

  There’s another theory that we have recessions every five years, but it hasn’t happened that way so far. I’ve looked in the Constitution, and nowhere is it written that every fifth year we have to have one. Of course, I’d love to be warned before we do go into a recession, so I could adjust my portfolio. But the odds of my figuring it out are nil. Some people wait for these bells to go off, to
signal the end of a recession or the beginning of an exciting new bull market. The trouble is the bells never go off. Remember, things are never clear until it’s too late.

  There was a 16-month recession between July, 1981, and November, 1982. Actually this was the scariest time in my memory. Sensible professionals wondered if they should take up hunting and fishing, because soon we’d all be living in the woods, gathering acorns. This was a period when we had 14 percent unemployment, 15 percent inflation, and a 20-percent prime rate, but I never got a phone call saying any of that was going to happen, either. After the fact a lot of people stood up to announce they’d been expecting it, but nobody mentioned it to me before the fact.

  Then at the moment of greatest pessimism, when eight out of ten investors would have sworn we were heading into the 1930s, the stock market rebounded with a vengeance, and suddenly all was right with the world.

  PENULTIMATE PREPAREDNESS

  No matter how we arrive at the latest financial conclusion, we always seem to be preparing ourselves for the last thing that’s happened, as opposed to what’s going to happen next. This “penultimate preparedness” is our way of making up for the fact that we didn’t see the last thing coming along in the first place.

  The day after the market crashed on October 19, people began to worry that the market was going to crash. It had already crashed and we’d survived it (in spite of our not having predicted it), and now we were petrified there’d be a replay. Those who got out of the market to ensure that they wouldn’t be fooled the next time as they had been the last time were fooled again as the market went up.

  The great joke is that the next time is never like the last time, and yet we can’t help readying ourselves for it anyway. This all reminds me of the Mayan conception of the universe.

  In Mayan mythology the universe was destroyed four times, and every time the Mayans learned a sad lesson and vowed to be better protected—but it was always for the previous menace. First there was a flood, and the survivors remembered it and moved to higher ground into the woods, built dikes and retaining walls, and put their houses in the trees. Their efforts went for naught because the next time around the world was destroyed by fire.