Investing Lessons: Avoiding the Peter Lynch Bias

by Charles Sizemore | November 12, 2012 7:00 am

The single most important lesson I’ve learned about being a successful investor is the need to maintain emotional detachment.  Any feelings you may have towards a stock are unrequited.  If you love a stock, it will not love you back.  And if you hate a stock, it will not give you the satisfaction of responding in kind.  (As tragic as unanswered love may be, unanswered hate is often more damaging to your pride.)

A stock is like that unattainable cheerleader you had a crush on in high school.  She neither loved you nor hated you; she was completely unaware you existed.

No matter how much you love a stock (and write favorably about it in MarketWatch) it will not reward your loyalty by rising in price. And heaven help you if you allow your emotions to cloud your judgment in a short position.  I know of no surer way of losing your investment nest egg than to short a stock or other investment you hate.  Alas, I know from experience; I shorted the Nasdaq 100 in the fall of 2003.  In an outbreak of moral high-horsing that has (thankfully) now been purged out of me, I decided that tech stocks were overpriced and needed to fall further.  The Nasdaq had very different ideas, and I was forced to cover that short at a 20% loss with my tail tucked between my legs.

A closely-related investment mistake is succumbing to what I call the “Peter Lynch bias.”

Peter Lynch ran the Fidelity Magellan fund from 1977 to 1990 and had one of the best performance records in history for a mutual fund manager—an annualized return of over 29% per year.

Unfortunately, he also offered some of the worst advice in history when he recommended that investors “invest in what they know.”

On the surface, it seems like decent enough advice.  If you stumble across a product you like—say, a particular brand of mobile phone or a new restaurant chain—then it might be reasonable to assume that others will feel the same way.  If the stock is reasonably priced, it might make a good investment opportunity.

Unfortunately, “investing in what you know” tends to create muddled, emotionally baggaged thinking.  The fact that you like Chipotle (NYSE:CMG[1]) burritos and are intimately aware of every ingredient used in the red salsa does not automatically make Chipotle a good investment any more than your liking of Frappuccino makes Starbucks (NASDAQ:SBUX[2]) a good investment.   Rather than give you an insightful edge, liking the product causes you to lose perspective and see only what you want to see in the stock.

How do we mitigate our emotional impulses?

In a prior article, I noted that “brain damage can create superior investment results[3].”  But short of physically re-wiring our brains, what can we actually do?

I try to follow these basic guidelines and recommend them:

Admittedly, these are not precise guidelines.  But then, another lesson I learned is that it is a mistake to try to be too precise in this business.  Follow the lead of great value investors like Benjamin Graham and Warren Buffett by making sure you have a wide margin of safety in your assumptions.

Endnotes:
  1. CMG: http://studio-5.financialcontent.com/investplace/quote?Symbol=CMG
  2. SBUX: http://studio-5.financialcontent.com/investplace/quote?Symbol=SBUX
  3. brain damage can create superior investment results: http://www.marketwatch.com/story/risk-perception-makes-all-the-difference-2012-10-05
  4. AAPL: http://studio-5.financialcontent.com/investplace/quote?Symbol=AAPL
  5. GOOG: http://studio-5.financialcontent.com/investplace/quote?Symbol=GOOG
  6. RIMM: http://studio-5.financialcontent.com/investplace/quote?Symbol=RIMM

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