3 Conditions That Unleash Extraordinary Returns

There's plenty of time to talk about the science of the stock market and the art of making money. However, this is not one of those times.

What I offer in this article are the three simple rules that will help investors perform better. For the skeptics, I'll present evidence. For the needy, I'll offer methods you can adopt as your own.

You won't find any B.S. here -- just three simple strategies to help you crush the market.

Condition 1: Purchase great companies at reasonable prices, and hold them for the long term.
Of all the sweeping conclusions that have been made about the stock market and its performance over the years, the most convincing, by far, is that buying great businesses and holding them for the long term is the most effective way to beat the market. The strategy reduces the costs of trading, it reduces the chances of being out of the market during massive bull markets, it seriously reduces the chances of making stupid mistakes, and it is embraced by most of the great investors of our time. It works.

There are many heavyweights out there who've researched this topic exhaustively. We can start with Jeremy Siegel's seminal Stocks for the Long Run. In addition, a watershed study by Barber and Odean looking at accounts at a large discount broker showed that active traders tend to lose to the general market by 6.5% annually. A more recent brokerage study confirms the finding. As Jason Zweig of The Wall Street Journal reports, "An analysis of nearly 2 million trades by discount-brokerage customers found that those who traded the most earned returns no higher than those who traded the least. After deducting brokerage costs, the fastest traders fell far behind the slowest."

If you're serious about beating the market over the long term, you'll start by respecting this general philosophy. In my own portfolio, taking this approach has meant taking large positions in fantastic, built-to-last companies such as Walt Disney (NYSE: DIS  ) , PepsiCo (NYSE: PEP  ) , and Diageo (NYSE: DEO  ) and just sitting on them. These investments represent the vast majority of my stock portfolio, and I don't mess around with them. They're my workhorses.

Condition 2: Capitalize on large, unusual, emotionally driven events in the market.
All work and no play makes Jack a dull boy.

Much as I would like to follow the investing gods of good 100% of the time, occasionally I drift to the dark side. Everyone needs to have fun. Well, having fun is fine; just be smart about it.

First, dedicate only a small portion of your assets to higher-risk investing like this. Most investors should keep this allocation to around 5%-10%. Second, do it in an intelligent, non-speculative manner. That means do your homework.

If you're trying to supercharge your portfolio returns and have some fun at the same time, I believe it's best to indentify super-cheap businesses that are being crushed by temporary, irrational events. I'll give you two quick examples from my own portfolio.

Back when the market was falling apart in February 2009, I was drop-dead certain one industry wasn't going much lower: oil. At just $35 a barrel after plunging from $150 a few months before, oil just seemed excessively cheap. So I did the natural thing and bought an oil-services ETF loaded with huge players such as Halliburton. It was a risky bet, yes. In retrospect, I probably should have spent more time examining the economics of the business involved. But man, I just knew that was an irrational market at work, and I had to act on it.

A better example would be video-game manufacturer Take-Two Interactive (Nasdaq: TTWO  ) . In early December, Take-Two presented disappointing quarterly numbers to a crowd of agitated analysts. The next day, the stock was blasted by about 30%. Even before that spanking, I knew that the company had plenty of valuable assets in its control and was already relatively cheap. What I discovered the next day was that the analysts covering the stock had now had enough of the company's poor recent performance and were unwilling to stick around. So I stepped in and put a 3% portion of my portfolio to work. Apparently, other contrarian investors -- including Carl Icahn -- saw the same thing.

In both cases, I took on significant risk, and I guess you could say I got somewhat lucky. But when you're making decisions based on irrational events and doing it intelligently, you're really increasing your chances of success. As Baron von Rothschild said, you have to "buy when there's blood in the streets."

Condition 3: Identify combinations of the two.
If you're fortunate enough to find the nexus of the two conditions, you've hit gold. Warren Buffett nailed it with American Express (NYSE: AXP  ) in the '90s. Numerous investors did it with Johnson & Johnson (NYSE: JNJ  ) in the '80s, after the Tylenol scandal. Today, perhaps a few will be able to do it with Toyota Motors (NYSE: TM  ) . At least I think so. There are no sure things in investing, obviously.

When you find excellent businesses being discounted for irrational, mainly emotional reasons and you're prepared to hold for the long term, your chances of success are huge. It's that simple.

The Foolish bottom line
As I said at the beginning, there's no baloney here. Build the majority of your portfolio around great companies purchased at reasonable prices, and hold on tight. If you must play around with more risk, limit it severely to cheap companies that are temporary discounted. Always, however, be prepared to pounce on the rare combination of a great business and an irrational market. That's it.

Now, because I generally prefer to steal other people's great ideas rather than create my own, I look to outside sources to help fuel my process. Among other choices, I regularly turn to the Fool's own market-beating Inside Value service for these ideas. In fact, I own several of the service's recommendations and have had great success with them. You can look at the portfolio yourself completely free for 30 days. Just click here to start making your own rules.

Nick Kapur owns shares of Disney, Diageo, Pepsi, Take-Two, and that oil-services ETF, SPDR S&P Oil & Gas Equipment Services (oil is still too cheap). American Express and Walt Disney are Motley Fool Inside Value picks. Take-Two Interactive Software is a Motley Fool Rule Breakers recommendation. Walt Disney is a Motley Fool Stock Advisor choice. Diageo, Johnson & Johnson, and PepsiCo are Motley Fool Income Investor picks. Motley Fool Options has recommended a buy calls position on Johnson & Johnson and a diagonal call position on PepsiCo. The Fool has a disclosure policy.


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