Peter Lynch: The Cocktail Theory

In a world where professional economists and forecasters struggle to predict markets, the Cocktail Party Theory offers an unconventional perspective. This theory, developed through social observations, focuses on predicting market movements, although Peter Lynch advocates for buying undervalued great companies instead. The following article is an excerpt from Peter Lynch's book "One Up On Wall Street".

If professional economists can't predict economies and professional forecasters can't predict markets, then what chance does the amateur investor have? You know the answer already, which brings me to my own Cocktail Party Theory of market forecasting, developed over years of standing in the middle of living rooms, near punch bowls, listening to what the nearest ten people said about stocks.

In the first stage of an upward market-one that has been down awhile and that nobody expects to rise again-people aren't talking about stocks. In fact, if they lumber up to ask me what I do for a living, and I answer, “I manage an equity mutual fund," they nod politely and wander away. If they don't wander away, then they quickly change the subject to the Celtics game, the upcoming elections, or the weather. Soon they are talking to a nearby dentist about plaque. When ten people would rather talk to a dentist about plaque than to the manager of an equity mutual fund about stocks, it's likely that the market is about to turn up.

In stage two, after I've confessed what I do for a living, the new acquaintances linger a bit longer-perhaps long enough to tell me how risky the stock market is before they move over to talk to the dentist. The cocktail party talk is still more about plaque than about stocks. The market's up 15 percent from stage one, but few are paying attention.

In stage three, with the market up 30 percent from stage one, a crowd of interested parties ignores the dentist and circles around me all evening. A succession of enthusiastic individuals takes me aside to ask what stocks they should buy. Even the dentist is asking me what stocks he should buy. Everybody at the party has put money into one issue or another, and they're all discussing what's happened.

In stage four, once again they're crowded around me--but this time it's to tell me what stocks I should buy. Even the dentist has three or four tips, and in the next few days I look up his recommendations in the newspaper and they've all gone up. When the neighbours tell me what to buy and then I wish I had taken their advice, it's a sure sign that the market has reached a top and is due for a tumble.

Do what you want with this, but don't expect me to bet on the cocktail party theory. I don't believe in predicting markets. I believe in buying great companies-especially companies that are undervalued, and/or underappreciated. Whether the Dow Jones industrial average was at 1,000 or 2,000 or 3,000 points today, you'd be better off having owned Marriott, Merck, and McDonald's than having owned Avon Products, Bethlehem Steel, and Xerox over the last ten years.

You'd also be better off having owned Marriott, Merck, or McDonald's than if you'd put the money into bonds or money-market funds over the same period. If you had bought stocks in great companies back in 1925 and held on to them through the Crash and into the Depression (admittedly this wouldn't have been easy), by 1936 you would have been very pleased at the results.