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Collection: Peter Lynch - #50 'Risk vs. Reward'



Once you have built the story for your company, you have a powerful tool for judging the stock. But like any powerful instrument, you must use it wisely and carefully or you will get burned.

Use your story to pick the right time to buy a stock. I promise you that the right time to buy a stock does not occur often. When I am following a stock, buying opportunities present themselves once or twice a year if I am lucky.

I look for times when the potential upside is high and the potential downside is reduced. Understanding that balance is a key to successful stock investing. You have to understand, stock picking is a risk reward trade-off. You have to know how much you are going to lose if you are wrong and how much you are going to make if you are right. The skill is to minimize your risk and maximize your reward.

You can be wrong in this business. I have been wrong quite a bit. But you can be wrong and still make money as long as you have good stocks that more than offset your mistakes. I figure if I could be right 6 times out of 10, that’s a good batting average.

When I pick stocks, I think of risk as a measure of my confidence in the story I have built. When I feel that my story is optimistic, solid and well researched then I have got a low-risk investment. If I am not too sure about how the story will turn out, then the risk is considerably higher.

Don’t try to categorize risk by other measures, like small companies are riskier than large. In the late 1970s or the early 1980s Walmart was a lower risk investment than IBM because the Walmart story was nearly bulletproof.

If a start-up company sounds exciting keep an eye on it. Perhaps a year or two later it will be over the hump, the story will be solid and there is a good time to consider investing.

If you believe strongly in your company’s story, then you should not waste your time waiting for the ultimate buying opportunity. Investors who bought McDonald’s in the 1970s or Home Depot in the 1980s were happy almost any time they bought the stock. Even with these great companies during stock market corrections, the stock dipped and the story was solid. But if you held on for a reasonable amount of time you are a very happy camper.

Watch out for ridiculously high prices when a company is selling at several times its growth rate and earnings. Remember that’s what we talked about in the price earnings presentation.

But in general, if a story is good you probably want to own it. Later, if a buying opportunity comes along, the stock falls well below its growth rate and the story hasn’t changed you can buy even more. Therefore, you can take advantage of market declines.

Use the tools I have presented in this consultation to help make a judgment on your stock. If the story is sound, check the price, use the P/E ratio. Most importantly rely on your edge first to build your story then to find the right times to add or reduce your position.

Focus on the company. What is it making? Where is its money coming from? What is the competition doing? Ignore all the background noise. Just keep checking that fundamental story, see if it is valid, see if it is getting better, see if it is getting worse. Know what category your stock is in and how those stocks behave. If your stock isn’t behaving as you expect, try and find out why.



[YAPSS Takeaway]

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