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I believe in stocks. Despite periods of turbulent economic and political climates, stocks have historically triumphed. Stocks and stock funds, bonds and bond funds, and cash (in the form of money market funds, Treasury bills, savings accounts, or other short-term investments) are the centerpieces of your investment program. Let's review a bit about each one. Stocks I believe in stocks. Whether you own shares of individual companies or shares in stock mutual funds, you're investing in stocks. If you look at the returns of the last 72 years, stocks are the undisputed champs. Despite periods of turbulent economic and political climates, stocks have triumphed. They've outgained money markets, savings accounts, and Treasury bills. They've outgained corporate bonds, government bonds, and junk bonds. By a lot! As Chart 5 illustrates, $1,000 invested in the stock market in 1925 is worth more than $1.8 million today. That purple line rising above the others is a beautiful sight for a stockholder to contemplate. What's behind this remarkable rise? What causes stocks to go up? Baby Boomers pouring money into mutual funds? That's the latest popular theory, but it's misguided. Baby Boomers may help nudge stocks up the slope of prices, but they aren't the prime movers. Over the past six years and, in fact, the past 106 years, stock prices have risen with corporate earnings, also known as profits. Chart 5 In sto buyer "earn earni earni 1 of 4 7/5/2000 4:45 PM Fidelity Investments: Peter Lynch on Investing: Key Things Every Investor Should Know http://personal300.fidelity.com/planning/...content/peterlynch/keythings/s3/?ref=key1

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Page 1: S Stocks - NYUpages.stern.nyu.edu/~igiddy/ing-barings/lynch on investing.pdf · shares in stock mutual funds, you're investing in stocks. If you look at the returns of the last 72

I believe in stocks. Despite periods of turbulenteconomic and political climates, stocks havehistorically triumphed.

Stocks and stock funds, bonds and bond funds, and cash (in the form ofmoney market funds, Treasury bills, savings accounts, or othershort-term investments) are the centerpieces of your investment program.Let's review a bit about each one.

Stocks

I believe in stocks. Whether you own shares of individual companies orshares in stock mutual funds, you're investing in stocks. If you look at thereturns of the last 72 years, stocks are the undisputed champs. Despiteperiods of turbulent economic and political climates, stocks havetriumphed. They've outgained money markets, savings accounts, andTreasury bills. They've outgained corporate bonds, government bonds,and junk bonds. By a lot!

As Chart 5 illustrates, $1,000 invested in the stock market in 1925 isworth more than $1.8 million today. That purple line rising above theothers is a beautiful sight for a stockholder to contemplate. What's behindthis remarkable rise? What causes stocks to go up? Baby Boomerspouring money into mutual funds? That's the latest popular theory, but it'smisguided. Baby Boomers may help nudge stocks up the slope of prices,but they aren't the prime movers. Over the past six years and, in fact, thepast 106 years, stock prices have risen with corporate earnings, alsoknown as profits.

Chart 5

In stocks, thebuyers' motto is"earnings,earnings,earnings."

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Provided by Ibbotson Associates. "Stocks, Bonds, Bills and Inflation 1997 Yearbook."Used with permission, all rights reserved. This chart is not intended to imply the past orfuture performance of any particular Fidelity fund or other investment product and pastperformance is no guarantee of future results. Common stocks represented by the S&P 500.Treasury bills represented by the 30-day U.S. Treasury Bill. Intermediate governmentbonds are represented by the 5-year U.S. government bond. Inflation is represented by theConsumer Price Index. The S&P 500 includes reinvestment of any dividends and capitalgains. Unlike common stocks, U.S. Treasuries offer a fixed rate of return and guaranteepayment of principal if held to maturity.

For every dollar in sales that lands in the cash register, the typicalcompany earns between 3¢ and 6¢ cents in profit. 94¢ to 97¢ cents is lostto expenses and taxes (Haver Analytics, 1998). It's the last few cents inprofit that put Wall Street on the map and creates the market for sharesworldwide.

If a company does well, its sales go up and its profits go up, and the priceof its shares go up too. (See Chart 6.) That explains why Baby Boomerbuying hasn't helped the stock price at Bethlehem Steel. Today,Bethlehem sells for less than half the price it sold for 30 years ago. Why?The company earns less per share than it did 30 years ago.

Chart 6

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Note: The Dow leads changes and profits, so its yearly changes are related to the followingyears' changes in profits. Sources: Historical Statistics of the United States: ColonialTimes to 1970; Finance & Investment Handbook, Barrons; The Wall Street Journal;Federal Reserve Economic Data Base, Federal Reserve Bank of St. Louis

While Bethlehem foundered, the combined earnings of a large crowd ofcompanies (the S&P 500) increased 54-fold over the last 52 years. (Nowyou see why it can be dangerous to own one stock – you might havechosen Bethlehem Steel!) Over the same 52-year period, the combinedstock prices of the companies in the S&P 500 were up 63-fold. That'swhat I'd call a strong correlation.

Here's a more recent example: since January 1992, through the firstquarter of 1998, S&P earnings are up almost 2.0 times, and guess what?The S&P 500 index is up 2.7 times. Had the earnings been lower since1992, I'm convinced stock prices would be substantially lower, in spite ofthe Baby Boomers and other eager buyers.

In real estate, the agents' motto is "location, location, location." In stocks,the buyers' motto is "earnings, earnings, earnings." For visual evidence,check Chart 7. When earnings are up, stocks prices are up; whenearnings are down, stock prices are down a lot more. This all makessense when you think about what you're buying when you buy stock.You're buying shares. Shares of what? Shares of a company's earnings.

Chart 7

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Includes reinvestment of dividends and capital gains.

© Copyright 1998-2000 FMR Corp.All rights reserved. Important Legal Information

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3. The big three of investing

Types of stocks

The major categories of stocks include growth stocks and value stocks.They are attached to growth companies and value companies,respectively. Here's a thumbnail sketch of each. I'll also say a few wordsabout dividends.

Growth companies

Growth companies increase their earnings steadily and fast – at morethan twice the rate of the average company. That being the case,investors pay a high price for these powerful earnings. A successfulgrowth company can keep up the pace for a decade or more, and a fewexceptional growers (McDonald's, Merck, and ADP, for example) havehad the stamina of marathoners. They may not slow down for 20 years orbeyond. But eventually most get tired and slacken the pace.

Microsoft is an example of a fast grower that hasn't slowed down yet.The first day of trading, the stock sold for 39¢ (adjusted for stock splits).Even three years later (March 1989) it was selling for only $1.39. But inthe summer of 1998, it sold for approximately $115. That's the sort ofpayoff that rewards stock pickers who hitch their money to anup-and-coming growth company. Wal-Mart, Federal Express, Staples,and Starbucks have been equally rewarding to early investors. And howabout the Circuit City example? On December 13, 1974, it sold for 2¢(adjusted for splits). By mid-summer 1998, 24 years later, it sold for $50,a 2,500-fold increase. That's a long-term growth stock.

Value companies

Value companies may not grow their earnings at all, but they ownvarious assets that make them attractive to investors. These assetsinclude real estate, cash in the bank, subsidiaries, new products comingoff the assembly line, a trusted brand name, etc.

Companies don't often start out as value companies. They're oftengrowth companies that run into trouble and stop growing. Wall Streetnotices and the stock falters because investors refuse to pay a high pricefor anemic earnings. Then, at some point, the stock gets cheap enoughthat investors are attracted to it once more. (See Chart 8.)

Chart 8

Why aredividends soimportant?They rewardinvestors forowning thestock.

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Includes reinvestment of dividends and capital gains.

Value companies that solve their problems and begin growing fast again(like Disney in the 1980s) are called turnarounds.

Companies that pay dividends

Some companies do, many don't. Fast growers that sink all their profitsinto their own expansion rarely pay dividends. Customarily, the biggestdividends are paid by mature, larger companies such as utilities, banks,and oil producers. Many value companies offer decent dividend yields aswell.

Why are dividends so important? They reward investors for owning thestock. In fact, over the past 52 years, dividends have accounted for morethan a third of the total returns from stocks. They play a huge role in whatmakes stocks valuable.

Since dividends come out of profits, they're never guaranteed. If acompany runs into trouble and earns zero, it usually suspends thedividend. Just because a company pays a $2 dividend this year, you can'tassume it will continue to pay it five years down the road.

A group of reliable dividend payers has been identified by the Moody'sInvestors Service. These solid "dividend achievers" have raised theirpayout 20 years in a row. Only a substantial and successful company canproduce such a record in good times and bad.

When stock prices aren't going up, dividends are the only reward you'llget. They can provide a "floor" under stock prices in a bear market,because as prices decline, the dividend rate increases, makingdividend-paying stocks attractive to new buyers. In recent years, dividendpayouts have fallen to their lowest levels in modern history (1.5 % on the

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companies in the S&P 500 as of first quarter, 1998). This is a dangersign, even though a lot of experts are ignoring it. Today's dividend ratesare so paltry that stock prices would have to fall a long way beforedividends would provide much of a floor.

© Copyright 1998-2000 FMR Corp.All rights reserved. Important Legal Information

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3. The big three of investing

Bonds

Although stocks are my favorite investments, I don't mind putting in agood word for bonds. Bonds can serve a useful function in your portfolio.Over short periods of time, bonds in general have been less volatile thanstocks.

What is a bond? It's a glorified IOU. The bondholder lends a specificamount – say $10,000 – to whomever issues the IOU. It could be thegovernment, a government agency, or a corporation. In return, thebondholder receives an interest payment on a regular basis at apredetermined rate. This borrower continues to pay interest to thebondholder until the original loan – $10,000 in our example – must bepaid back in full. That's the date, also determined in advance, when thebond "matures."

High yield bonds (also known as "junk" bonds in years past) aretypically issued by less-established companies, or companies that haveexperienced financial difficulties. Because the risk of default (thepossibility that your principal will not be returned) is greater than withother types of bonds, high yield bonds must pay a higher interest rate toattract buyers.

Rating agencies – principally Standard & Poor's and Moody's – givebonds a grade (AAA, BBB, etc.) based on their opinion of the financialstrength of the companies that issue the bonds. (High yield bonds aregenerally rated at the very bottom of the scale.) But even with suchratings readily available, the corporate bond market is hard to navigate.The average investor is generally better off buying U.S. governmentbonds, or investing in bond funds where a professional manager does thepicking.

Bonds come in many varieties. Long-term bonds don't mature for 10,20, 30, or as much as 100 years. So-called intermediate-term bondsmature in 1 to 10 years, and the short-term variety (these are calledTreasury bills, not bonds) mature in a year, six months, even as soon asthree months.

Let's say the U.S. government sells you a 10-year bond for $10,000. Thebond pays 6% interest, or $600 a year. You hand over your $10,000 andstart receiving the interest. Ten years later, you get your money back. Butyou aren't stuck with the government IOU for 10 years if you don't wantto be. You can sell it anytime (but remember, you could incur asubstantial gain or loss on any fixed income security sold before itsmaturity).

Bonds trade in the marketplace like stocks. In fact, in terms of thedollars it represents, the bond market (government bonds, corporates,and municipals lumped together) is almost as large as the stock market.Bond prices move up and down like stock prices, and the moves can beswift and extreme. These ups and downs are caused primarily by changesin interest rates.

The averageinvestor isbetter offbuying U.S.governmentbonds, orinvesting inbond fundswhere aprofessionalmanager doesthe picking.

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Using the example of your $10,000 bond paying 6%, if interest ratesrise, bond buyers will demand more than 6%. Therefore, you can't sellyour $10,000 bond for $10,000. Prospective buyers will pay less, say$9,500. They'll receive the same $600 a year interest as you did, but$600 interest on $9,500 comes out to 6.3%.

We'll discuss more about bonds and how they work in different marketenvironments in the next section.

© Copyright 1998-2000 FMR Corp.All rights reserved. Important Legal Information

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3. The big three of investing

Cash

When investment professionals talk about cash, they really meancash-equivalent vehicles such as savings accounts, certificates of deposit,money market accounts, or short-term Treasury bills. These all payinterest, and they all are "liquid" – meaning you can quickly convert theminto cash. For convenience sake, they are lumped together and referred toas cash.

Cash is often regarded as the world's safest investment, so people whoare afraid of stocks and bonds often keep their money in a savingsaccount or the money market. Does this make sense? Sometimes it does.In periods of high inflation, for example. More about that in the nextsection.

Beyond the occasional period when cash shines, it is a lousy investmentin the long run. As you can see on Chart 9, it runs a distant fourth tostocks, long-term corporate bonds, and long-term government bonds intotal returns since 1926. The gap between the winning contestant(stocks) and the rest of the field is staggering. Cash kept you slightlyahead of inflation over 72 years, and $1,000 parked in a savings accountturned into $14,250. The same $1,000 invested in stocks turned into $1.8million!

Chart 9

Provided by Ibbotson Associates, "Stocks, Bonds, Bills and Inflation 1997 Yearbook."Used with permisssion, all rights reserved. This chart is not intended to imply the past or

Beyond theoccasionalperiod whencash shines, itis a lousyinvestment inthe long run.

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future performance of any particular Fidelity fund or other investment product and pastperformance is no guarantee of future results. Common stocks represented by the S&P 500.Corporate bonds represented by the Salomon Brothers long-term, high grade, corporatebond total return index, and government bonds measured by a one-bond portfolioconstructed by Ibbotson. The indices are unmanaged and include reinvestment of anydividends and capital gains for the S&P 500. Cash represented by the 30-day U.S. TreasuryBill. Unlike common stocks, corporate bonds, and some government bonds, U.S. Treasuriesoffer a fixed rate of return and guarantee payment of principal if held to maturity.

Go to 4. What can go wrong, and how to preparefor it

References to specific companies are used throughout this booklet only as examples andshould not be construed as offers or recommendations.

© Copyright 1998-2000 FMR Corp.All rights reserved. Important Legal Information

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Investing is a lifetime pursuit. You get better atit with experience.

Of all the investment decisions you'll make, the most important is assetallocation – deciding how to divide your assets between the Big Three:stocks, bonds, and cash (the money market). The choices range from veryaggressive to very conservative to something in-between. A widely citedstudy of pension plan managers shows that 91.5% of the differencebetween one portfolio's performance and another's is explained by assetallocation (Brinson, Singer, and Beebower, Financial Analysts Journal,1991). Asset allocation can be more important than picking a winningmutual fund.

A look at different mixes

The right mix of stocks, bonds, and cash can help you manage risk asyou look for higher returns. I’ve included two charts here to illustrate.Chart 14 delineates the "efficient frontier," a fancy term for thehypothetical mix of assets that shows you, historically, the highestexpected return of all portfolios with identical risk. This may surpriseyou, but a portfolio of 100% bonds actually has had more downside riskand less return historically than a portfolio of 20% stocks, 50% bonds,and 30% cash.

Chart 14

The key is tochoose a mixon the"frontier" thathas a level ofrisk you canlive with and isin line with yourexpectations.

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Chart 15 shows the results produced by different mixes of stocks, bonds,and cash over the past 10 years. You’ll notice that there’s no free lunchhere; if you try to limit your risk by choosing a mix with less risk (on theright hand portion of the chart), historically you also limit your return.The key is to choose a mix on the "frontier" that has a level of risk youcan live with and is in line with your expectations. (Being "efficient" is abad idea if you're worried all the time.)

Chart 15

You need to ask yourself: What kind of investor am I – can my stomachtolerate a big drop in the market? How long can I wait before I tap intomy portfolio? What do I plan to do with this investment? It nets out tounderstanding (1) your personal risk tolerance, (2) your timeframe, and(3) your goals.

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