As investors, performance is the final result of all the work that you do. You can intently study every aspect of the overall economy, particular industries, and specific companies and their competitors. You can pull up charts of past price movements and perform technical analysis to try to find trends and levels of support and resistance. You can hypothesize theories about what the future will bring. In the end, however, if the stock price doesn't respond favorably, your investment won't help you achieve your goals.
So if someone were to tell you about four stocks they thought had some pretty good prospects for growth and stock price appreciation, you might immediately ask about their past performance. If you found out that two of the stocks were up 800% and 16%, respectively, while the other two were down 31% and 47%, what conclusions would you draw?
It takes all kinds to make a market
With so little information, there are many reasonable responses. Some typical investors might take a glance at the four stocks and pick the big winner, thinking that any company so successful can only continue to rise. They would avoid the stocks that performed badly, afraid that they would lose money by investing in them. If you wanted to put a label on this group, you might call them "growth" or "relative strength" investors.
On the other hand, some would look at the high-flying stocks and decide that they'd had their day in the sun. What goes up must come down, they'd say; instead, they'd take a closer look at the stocks whose prices had fallen. Since they'd also believe that what comes down must go up, they might see the best prospects in those beaten-down stocks. You might call these folks "value investors."
Regardless of which style of investing you chose, you'd want to evaluate your decision to see whether you'd made the right choice. You could do that in a number of ways: by looking at the company's profits, its market share, or the relative success of its competitors. In the end, though, you couldn't avoid looking at the stock price. Even if you're investing for the long term, it's hard to ignore the share price weeks or months after you buy, and harder still to avoid drawing conclusions based on how that price has moved.
The catch
As some of you may have guessed, the hypothetical situation above involved a trick question. Those returns don't belong to four stocks, but rather to the same stock: Dell (NASDAQ:DELL). Over the past 10 years, Dell has risen more than 800% with an annualized return of 24% per year. Much of that gain, however, happened in the first three years of that decade; the stock is down 47% since October 1999, for an annualized return of -8%. In the past year, the stock has fallen 31%, but after hitting a closing low below $20 on July 21, the stock has risen 16%.
It's obvious that people who chose to invest in Dell at different times got very different results from their investments. Similarly, when you make a new investment, you won't know when the perfect time will be.
Know your strategy
Successful investors use a wide variety of different methods to make money. Some buy stocks they think will perform well over decades, and hold them through thick and thin. Others trade in and out of stocks using techniques that enable them to clip profits at opportune times. Similarly, investors take steps to control their risks in a number of different ways. Some choose price levels at which they will sell their stock no matter what. Others take price drops as an opportunity to invest more heavily.
The success of many different investment methods clearly shows that there's no one right way to invest. Yet many successful investors would say that there's one right answer for themselves, because the particular strategy they've chosen works well with their temperament and their personality. If you're bored by the financial pages and prefer not to look at your investments until your quarterly statements arrive in the mail, you probably won't do well with a strategy that requires you to make trades several times a day. And if you find yourself itching to check the prices on your stocks every 15 minutes, you'll likely struggle to maintain the discipline involved in buying and holding stocks for the long term.
Even once you choose a general strategy that works for you, it doesn't mean you shouldn't use other strategies from time to time. If you're generally a buy-and-hold investor, but you see the opportunity to make a quick profit using a short-term trading strategy, that's fine. Just remember one important thing: Your decision on that stock was motivated differently than your decisions on other stocks. Stick with your strategy. If the short-term opportunity passes, follow the short-term strategy and get out. Don't fool yourself into using your buy-and-hold strategy for that stock, because you didn't buy the stock with that strategy in mind.
Similarly, evaluate your investments consistently with your strategy. If you've chosen a stock because you believe it will perform well over the next 10 years, don't dump it just because it falls 5% in the first quarter after you buy it. On the other hand, even if the stock does well in the first months or years you own it, you should consider selling early if some of the initial conditions that justified your positive assessment of the stock change for the worse.
When you choose an investment, you won't know for sure whether it will be successful or not. Too many investors trade instinctively, based on emotional responses to changing conditions. By choosing an overall strategy that you can follow comfortably, you have the best chance of resisting those emotional responses and making rational decisions based on the facts, increasing the odds that your investment will be successful.
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Fool contributor Dan Caplinger usually buys for the long term but occasionally makes plays for a quick buck with varying degrees of success. He doesn't hold positions in Dell, which is also a Motley Fool Inside Value selection. The Fool's disclosure policy is part of a winning strategy.
