A Tour of the Fund House: Peter Lynch's Guide to Mutual Funds
Book: Beating the Street by Peter Lynch with John Rothchild | ISBN: 978-0-671-75915-5
Mutual funds were supposed to make investing easy. Instead of picking stocks yourself, you just pick a fund. But here’s the thing. By the early ’90s there were more mutual funds than individual stocks on the New York and American exchanges combined. So now you had to pick from 3,565 funds. The confusion didn’t go away. It multiplied.
Lynch helped a nonprofit organization redesign its portfolio. The issues they faced were the same ones every regular person faces. How much in stocks? How much in bonds? Which funds? This chapter is basically Lynch walking you through the answers.
Stocks vs. Bonds: The Math That Should Change Your Mind
Lynch lays out three scenarios using $10,000 over 20 years. The numbers are hard to argue with.
All bonds (7% interest): You collect $14,000 in income over 20 years. Then you get your original $10,000 back. That’s it. No growth.
Half stocks, half bonds: You get $10,422 from bond interest plus $6,864 from stock dividends. Your portfolio grows to $21,911.
All stocks (3% dividend, 8% growth): You collect $13,729 in dividends. Your portfolio balloons to $46,610.
Read that again. The all-stocks portfolio generates almost as much income as the all-bonds portfolio. And your money grew to more than four times what you started with.
Even Retirees Need Stocks
People always say retirees should own bonds for safety. Lynch disagrees. A healthy 62-year-old might live another 20 years. That’s 20 years of inflation eating away at buying power.
So Lynch runs another scenario. Say you have $100,000 and need $7,000 a year. Instead of bonds, you put everything into stocks paying a 3% dividend. Year one, dividends give you $3,000. You sell $4,000 of stock to cover the gap. Your portfolio, growing at 8%, ends the year at $104,000.
Every year the gap shrinks. By year 16, dividends alone exceed $7,000. After 20 years your $100,000 has grown to $349,140. Even if the market crashes 25% right after you buy, you still end up with $185,350. Nearly double a $100,000 bond.
Peter’s Principle #5: “There’s No Point Paying Yo-Yo Ma to Play a Radio”
Lynch’s take on government bond funds. One Treasury bond is the same as the next. There’s nothing a manager can do to make one perform better. So why pay fees? Buy Treasuries directly from a Federal Reserve bank with no commission.
A study showed bond funds were consistently outperformed by individual bonds, sometimes by 2% a year. The management fee was eating the returns.
75% of Fund Managers Can’t Beat the Index
This is the stat that stings. Over the prior decade, up to 75% of equity fund managers failed to beat the S&P 500. Eight years in a row. If a manager even matched the market, they ranked in the top quartile.
Lynch talks about this with Michael Lipper, the number-one authority on mutual funds. If you’d put $100,000 in the Vanguard 500 index fund on January 1, 1983, you’d have $308,450 by 1991. The average managed fund? Only $236,367. That’s a $72,000 difference.
So should you just buy index funds and call it a day? Lynch says that’s actually not a bad idea. But he also thinks you can do better if you pick the right managed funds. The key is understanding the different types.
Build a Team of Six Funds
Lynch breaks equity funds into five types:
- Capital appreciation funds where managers can buy anything (Magellan was one of these)
- Value funds focused on companies whose assets are worth more than the stock price
- Quality growth funds invested in established companies growing 15%+ a year
- Emerging growth funds focused on small companies
- Special situations funds invested in companies where something unique has changed
His advice: divide your money into six parts. Put one in each type, plus a utility or equity-income fund for stability. Different styles win in different years. Value funds crushed it for eight years before the 1987 correction. Then growth funds took the lead. You never know which style will be hot next. So own a little of everything.
The trick is comparing funds against their own type. Don’t blame a value fund manager for underperforming a growth fund when value stocks are out of favor. Compare value fund to value fund.
Load vs. No-Load? Don’t Overthink It
Some funds charge an upfront sales commission (load), some don’t. If you’re holding for years, the 2-5% load becomes insignificant. What matters more is consistency. The Forbes Honor Roll grades funds through both bull and bear markets. Of 1,200+ equity funds, only 9 had shown a gain in every calendar year since 1978.
Sector Funds, Convertibles, Closed-End Funds, and Country Funds
Lynch covers the specialty options too. Sector funds let you bet on an industry you know well. A jewelry store owner might know gold prices are about to rise. A doctor might spot a trend in biotech approvals. But sector funds are volatile. Fidelity Biotech went up 99% in 1991 and dropped 21.5% the next year.
Convertible bond funds mix bond stability with stock upside. The Putnam Convertible fund beat the S&P 500 over 20 years. Buy when the spread between convertible and corporate bond yields is narrow.
Closed-end funds trade like stocks on exchanges. When they sell at a discount to their portfolio value, that’s your buying opportunity.
Country funds let you invest in foreign markets. But timing matters. The Germany Fund got bid up to a 25% premium when the Berlin Wall fell. Six months later it was trading at a 20-25% discount. The lesson: buy country funds when nobody wants them.
This whole chapter is Lynch being honest about the fund industry. Most managers can’t beat the market. Bond funds are usually pointless. But if you build a diversified team of funds and stay patient, you can stack the odds in your favor.
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