Invest in What You Know? I Have a Better Idea.

banker-xIf there’s one sure thing that we know about the stock market, it’s that everyone has an opinion on how to make money. Unfortunately, many of those opinions aren’t worth much. However, if something is repeated often enough, people begin to accept it as truth even if they don’t totally understand it.

For example, let’s take “Invest in what you know.” Investment guru Peter Lynch popularized this phrase. He was amazingly successful during his time as manager of Fidelity’s Magellan Fund from 1977 to 1990.

Lynch’s words may seem simple, but there’s more to them than you might think. You see, the real secret to investment success might not be what you know, but rather whose knowledge do you trust.

Lynch was referring to investing in companies that you normally use. It sounds like common sense, but it actually overestimates the information necessary to make a wise investment. Yes, it makes sense for someone to invest in stocks with which they are familiar (i.e., a doctor who buys stock in a drug company), but the majority of shareholders don’t truly understand their company’s products, nor do they need to.

If everyone needed to understand product details in order to buy a stock, then half the people would be out of the stock market. Do people really know what Apple does? What Chevron does? What General Electric does?

The average guy may know something about retail because he buys some of those products himself. But that’s anecdotal evidence, not research evidence. The truth is that average guy doesn’t know his butt from his elbow.

The Starting Point

The lesson here is that Lynch’s advice is just the starting point for investors, not the end point.  If you believe in the company and you believe in the management, then buy the stock. Just make sure to do some extensive research beforehand just like Lynch himself would have done.

It’s hard to judge a company based on a single product’s performance. Instead, consider whether the company has expanding profit margins and earnings growth, and managers who have been successful at increasing the profitability of its product lines.

Next, do a technical analysis of stock trends to determine how the shares are likely to behave in the days ahead. But don’t just stop there or you’ll miss one the biggest keys to predicting a stock’s performance.

The Missing Key

You MUST find out what the company’s insiders are doing with their own shares. That information can be found by searching sites such as Yahoo! Finance or the Securities and Exchange Commission’s EDGAR database. Insiders are the likeliest to know the best time to buy or sell their company’s stock.

Here are three things you should be looking out for.

1. Review who’s doing the trading. The higher up on the ladder the insiders are, the more likely they are to have good information. Look for trades being made by the company’s top executives (i.e., CEO, president, CFO, etc.) rather than middle managers or outside shareholders.

2.  Find out how long has the insider buying or selling been occurring. A sustained period of insider buying is a strong indicator because executives generally don’t buy their firm’s stock unless they expect to make money. On the other hand, there are countless legitimate reasons why they could be selling their company’s stock. For example, they might want to buy a new house or pay for their kid’s college.

3.  Determine how many shares are being traded. If an insider trades 100 or 200 shares, then that’s not going to reveal anything important. If an insider trades 1 million shares, then that could be a signal of something major about to happen. However, there’s another possibility. If a trade was really based on inside information, an insider would probably try to disguise it by splitting the transaction up into smaller chunks over time.

If you follow this investment advice, you have the best chance of beating the markets. I won’t say that this is a simple investment strategy, because it’s not. But these are the same trading principles that I use to make money for my C.H.I.R.P. service subscribers.

Finally, Peter Lynch made a fortune for Fidelity in the early 80s by investing in Fannie Mae. He was one of the first to recognize that the company would profit immensely in the “mortgaged-backed securities” market.

I bet many of his clients back then couldn’t explain Fannie Mae’s business if their lives depended on it. But they knew enough to trust in the smart man who could. In the end, isn’t that all that really matters?

Note from Midas Legacy Editor: “Banker X” must remain anonymous for our purposes, but in his official capacity he’s a CNBC-quoted bestselling author. A former investment banking insider, Banker X is a multi-millionaire as a result of his inside contacts and continues to provide spectacular profits for subscribers to his C.H.I.R.P. service. Check your email for your exclusive invitation.

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