How Taking Profits Can Take Your Profits

Warren Buffett once quipped, "Only when the tide goes out do you find who's been swimming naked."

Last week, the tide went out. The Dow fell 450 points in a single day before recovering slightly. Even ExxonMobil (NYSE: XOM  ) -- the largest company in the world -- was worth some $25 billion less in a matter of hours.

Investors, needless to say, wanted to know why they felt naked.

You will always feel naked
No one can accurately predict the day-to-day movements of the market, but if (1) we know that bear markets exist and (2) we understand our original investment theses, we can avoid panic selling when losses start to pile up.

Instead, stick with your regular of plan of saving and investing. Over time, your returns will average out, and small, regular contributions could become a fortune.

Of course, talking about holding losses and actually doing so are two different things. When real money is involved, it's hard to keep the right perspective.

Meet Eddie ...
A little more than a year ago, Eddie, a member of our Motley Fool Hidden Gems small-cap investing community, was fed up. He'd been through a rough slug and had decided to sell his stocks, cut his losses, and move on.

It was hard to blame him at the time. He'd invested more than $250,000 in 11 stocks, including Deckers Outdoor (Nasdaq: DECK  ) , Portfolio Recovery Associates (Nasdaq: PRAA  ) , Grupo Aeroportuario (NYSE: PAC  ) , and Neenah Paper (NYSE: NP  ) , and was down more than $33,000. It was "especially painful," according to Eddie, because "I could have taken decent profits."

In other words, he could have sold and gotten out with some gains -- a clue that Eddie was never looking at his portfolio with an eye on the long-term. Curious to know how Eddie's investments fared since the day he cut his losses, I revisited his list of holdings. The results were astounding.

Getting philosophical
Before I get to just how astounding, let me tell you where Eddie went wrong.

I believe in the Hidden Gems philosophy: That in order to make your fortune in the stock market over the next few decades, you must be the patient long-term owner of high-quality, low-profile small companies. That means buying Nike (NYSE: NKE  ) before Michael Jordan supplied a massive marketing catalyst, or Best Buy (NYSE: BBY  ) when it was a small Midwestern electronics retailer with lots of cash and big plans, and then holding through inevitable ups and downs.

The rewards from such a strategy can be incredible. Nike has returned more than 23% annually over the past 20 years; Best Buy more than 24%. That's enough for either one of those stocks to have turned $10,000 into three-quarters of a million bucks.

In Deckers, Portfolio Recovery, Grupo Aeroportuario, Neenah, and the rest of his picks, Eddie had a handful of high-quality, low-profile small companies. What he didn't have was the patience to be a long-term owner. And that cost him.

And now ... the numbers
Fast-forward a year, and only one of Eddie's 11 companies would still be showing a loss. The average gain was nearly 40% -- with Neenah up 42%, Portfolio Recovery up 46%, Grupo Aeroportuario up 68%, and Deckers up 138%!

Unfortunately, we don't know in what proportions Eddie held these stocks. But if he had 11 equal positions, he would have swung from a $30,000 loss to a $60,000 gain simply through patience.

That could have been the easiest 60 grand Eddie ever made.

My point here is not to criticize Eddie, but to learn from his misfortune. Tough times happen in the market, and we need to remain focused on the long-term. Otherwise, we end up following our emotions rather than our reason and continually selling low after drops and buying high after runs. 

Learn to profit
Hidden Gems has had tremendous success over the past year, and was even rated the best-performing investment service by independent Hulbert's Financial Digest. We're well aware, however, that this next year could be very different.

Will we change our strategy? Will we stop buying stocks? Will we get scared into selling? No, no, and no. Our only goal at Hidden Gems is to be patient long-term owners of high-quality, low-profile small companies. If we do that, the gains will inevitably come.

To decide if our Hidden Gems strategies are right for you, click here to try the service free for 30 days. There is no obligation to subscribe.

Fool contributor Rick Casterline finds his favorite long-term holdings from his four-year-old subscription toMotley Fool Hidden Gems. He owns shares of Portfolio Recovery Associates. Best Buy is a Stock Advisor recommendation. The Motley Fool has a disclosure policy.


Read/Post Comments (4) | Recommend This Article (83)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 01, 2007, at 3:20 PM, Koblin wrote:

    I certainly agree that buying in for the long run is the only intelligent strategy. It is, however, important to keep your eye on the clock and investors who have been in the market for decades and no longer have decades to wait it out should reevaluate and perhaps sell to preserve and protect their gains. The market is not the place for those of us over 65.

  • Report this Comment On August 01, 2007, at 7:46 PM, marquiseduchatel wrote:

    Well,

    there are all sorts of reasons people invest. I do not think many of them are necessarily "wrong" headed or even "short" sighted..

    and one should also remember that there are very likely a large number (the number grows daily and will be a constant of the 'retirement' economy), who have been forced out of employment earlier than planned.

  • Report this Comment On August 03, 2007, at 12:26 PM, fsc137 wrote:

    Taxes are an important consideration. You should consider taking profits now, while you sure you can get a 15% capital gains rate. Congress could change the rate at any time, perhaps retroactively.

  • Report this Comment On August 03, 2007, at 8:33 PM, CrankyTexan wrote:

    <<< The market is not the place for those of us over 65. >>>

    Sure it is, as long as it is money that you don't need for at least 5 years.

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