Don't Follow the Crowd!

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How long does the typical investor hold on to a stock?

That was precisely the question asked in a recent article by Mark Hulbert. And the answer? An average of 11 months. That's preposterous! Let me tell you why.

First, it takes time -- much longer than a year, I should add -- for business projects to generate returns. By holding less than a year, investors don't allow enough time for development projects to run their course.

Second, turning a portfolio over once a year is like constantly switching the radio station in search of a better song. This behavior usually leads to disappointment and prohibits you from actually listening to any one song. Frustration ensues, which leads to more switching. In this way, the cycle continues.

Third, there are approximately 8,800 publicly traded companies. Obviously, they can't all be good investment ideas during the course of the year. If they were, investing would be easy.

So, as true Fools, let's exploit this unwise behavior on the part of the average investor and use it to our advantage.

First, let's buy companies with the goal of holding them for two to three years, regardless of short-term price movements. By extending our time frame beyond the average of 11 months, we won't get caught switching the radio before "Bohemian Rhapsody" (or your personal favorite song) comes on. Remember, an investment strategy based on switching stocks too frequently has been proven to underperform the market.

Next, let's buy stocks with catalysts that might arise in the future. Wall Street is always looking for a near-term catalyst. When there isn't one, Wall Streeters sell, thereby depressing prices. It's much easier and more profitable to buy ahead of catalysts than to buy after one is discovered. Of course, you have to know a little bit about the business, and the business has to be solid.

Finally, let's buy when the probability of decline is high but the magnitude is very low and the probability of advance is very low but the magnitude is high. Stocks get mispriced in the short term because of myopic loss-aversion behavior on the part of most investors. An aversion to future uncertainty by most investors also leads to temporary discrepancies between market prices and intrinsic values.

I think Cabela's (NYSE: CAB) and Motley Fool Hidden Gems selection DeckersOutdoor (Nasdaq: DECK) are two great examples of these principles right now. Cabela's is building for the long term and willing to sacrifice short-term. There's no near-term catalyst because opening retail stores costs lots of money, but the company is setting itself up to be a powerful force in the outdoor products market (watch this space for a future commentary on Cabela's).

Deckers is the same way. After two downward revisions to its quarterly numbers, shares have taken a beating. But the company is doing lots of good things to make sure it will be competitive and profitable in the future. Currently, Wall Street is ignoring Deckers' biggest catalyst, new CEO Angel Martinez, because it will take time for him to grow the business. Incidentally, Martinez purchased shares on the open market recently, so he obviously feels that the market is weighing Deckers' prospects incorrectly.

As Hulbert's article rightly points out, short-term shareholders create perverse incentives for managers. So let's do our part to break this trend. We'll get managers to start thinking long-term, while making lots of money holding stocks for the long term.

Fool contributor David Meier owns shares of Deckers Outdoor but not any of the other companies mentioned. The Motley Fool has a disclosure policy.