Stock Advice That Will Change Your Life

OK, so this article may not change your life -- but it may well change your investing behaviors.

That should change (for the better) the size of your brokerage accounts, which could allow for an early retirement or an Ivy League education for your kids -- which, of course, will change your life. So get comfortable.

"Buy good companies at cheap prices"
That's the standard (and thoroughly logical) stock advice that master fund manager Ron Muhlenkamp gives on how to beat the market. It seems completely obvious, but heck, thousands of folks ignore it every day by chasing whatever's new, shiny, and going up.

If you can pin down Muhlenkamp a little more, however, you'll end up with the life-changing information this article has promised.

Putting a preface on an epiphany
That's what we discovered when we visited Muhlenkamp at his investing seminar in Mars, Penn. But it wasn't until four hours into our visit that he revealed his "Three Things."

Before we get to the Three Things, however, let's look at a few of the reasons many investors -- professional and individual alike -- do poorly in the stock market.

Fail with the pros
First, when it comes to professional money managers, as Muhlenkamp tells it, there is "great pressure to be average." That's because if you have a bad year -- or even a bad quarter -- fundholders will start draining capital through redemptions. Money managers must then chase hot sectors, stray outside their circle of competence, and heed the consensus to not look stupid.

Of course, there's a Catch-22: In investing, "The only way I can be good is to be different."

But many so-called money managers aren't worried about managing money, according to Muhlenkamp. Rather, they're focused on marketing money management. And those are two very different topics.

Fail with the crowd
When it comes to do-it-yourself investing, short-term pressures are also a huge anchor.

Public markets date back to the 11th century. And from the 17th century's tulip mania to the 21st century's housing bubble, the boom and bust patterns are the same. Markets have been, are, and will forever be volatile in the short term because of emotion. (Just look at the plight of E*Trade in November -- down 59% one day, up 41% the next because of overreactions, speculation, rumors, and, to the point above, blocks of institutional selling.)

Yet we -- collectively -- do not learn. As Muhlenkamp noted, "The crowd hasn't learned anything. Individuals have. The crowd hasn't."

You can profit from this (as you will see later), or you can fall victim to it. Those who fall victim are the same people who have written to us personally to accuse us of manipulating popular, high-volume (and richly valued) stocks such as TASER (Nasdaq: TASR) or SunPower (Nasdaq: SPWR). (Hint: We haven't. We won't. We never will.)

Before we insult anyone ...
OK, enough preface. Let's get to Muhlenkamp's Three Things. First, a warning: They won't be for everyone. As Ron says, "Some get it. Some don't."

But they are hugely valuable. Read them. Think about them. Read them again. Put them on your fridge. And apply them to your investing. Give them a fair try, and they'll work.

They are:

1. A consistent philosophy
2. A sense of perspective
3. Daily discipline

Some color
Now, there are many investing philosophies out there. The key is to find the one that works for you and stick with it. At Motley Fool Hidden Gems, we're investors of the small-cap value persuasion because this strategy has historically earned the highest returns. We also like the way professional Wall Street investors tend to overlook small stocks. This has two benefits: Management is more accessible, and smaller companies' shares can be priced inefficiently.

We need perspective to recognize that even the best philosophy will not work 100% of the time. Indeed, in 2007 and through the early days of 2008, the small-cap value stocks we search for in Hidden Gems have been handily outperformed by large-cap growth (measured by the Nasdaq 100), which surged on the back of Intuitive Surgical (Nasdaq: ISRG), Apollo Group (Nasdaq: APOL), Millicom International Cellular (Nasdaq: MICC), and Steel Dynamics (Nasdaq: STLD), all up 50% or more over the past 13 months.

At best -- with apologies to Brian Fantana -- a consistent philosophy will work all the time ... just 60% of the time. Having perspective, however, will help you see the market's cycles and know when to be in cash, when to invest, and when to panic (hint: never).

Discipline, Muhlenkamp admits, is the most difficult to achieve. If you have the first two, you see, you have them forever. But daily discipline is a daily battle. Every investor has the urge to bail out when a stock starts tanking. The key is not to. You may still sell, but you want to do so rationally -- and with good evidentiary reasons.

Information is power
Philosophy, perspective, discipline. It's what has made Ron Muhlenkamp successful for going on four decades, and it's what we work to achieve every day at Hidden Gems. We're not perfect, but our picks on average are 18 percentage points ahead of the market. If you'd like to see those picks at no cost or join us in practicing those Three Things, click here to get started. There is no obligation to subscribe.

This article was first published Nov. 30, 2007. It has been updated.

Neither Tim Hanson nor Brian Richards owns shares of any company mentioned in this article, although both Tim and Brian own shares in Ron Muhlenkamp's excellent mutual fund. Tim and Brian love Nerf football. And yes, Tim and Brian are just looking at things around the office and saying they love them. Intuitive Surgical and Taser are Rule Breakers recommendations. The Fool has a disclosure policy.