Get Ready for a 25% Drop

My friend swears he's learned his lesson.

Back in July 1995, this friend -- let's call him Charlie -- bought Microsoft at what turned out to be the highest price it would reach that year. The stock was down 15% in no time, and Charlie was worried. He was smart enough to know the market is the best wealth-creating machine available to us regular folks, but stocks to him were sort of like husbands to Elizabeth Taylor. He liked them well enough, but he tended to give up when things got a little rocky.

In a matter of weeks, his paper loss was approaching 25%, and he couldn't stand it anymore. He bailed out.

Needless to say, the next few years were even rougher on Charlie as he watched Mr. Softy march steadily higher. It achieved 10-bagger status at the height of the bull market in 2000, but even today it's more than 200% higher than when he sold.

The downs and the ups
As Tom and David Gardner tell their Motley Fool Stock Advisor members, you have to expect significant dips from some of your stocks, and you must remain firm if you've done your homework. Otherwise, you sort of screw up that legendary investing formula by buying high and selling low.

We've been through some rough times recently. At one point in 2008, the S&P 500 had fallen 50%. However, we believe that quality stocks at historically low multiples are the seeds of the next bull market. We're always willing to sell companies that no longer measure up, but we think it would be a big mistake to sell those whose investing thesis hasn't changed.

An interesting lesson can be gleaned from the last bear market. Here are some true all-star performers from the past decade, yet investors who bailed out on them missed out on some big gains.

Returns adjusted for dividends, courtesy of Capital IQ.
*Prior to current bear market.

So, the lesson Charlie learned is that practically all of the great superstar stocks of the past decades have dropped at least 25% at one time or another. It would be very hard for you to find one that hasn't.

Hey, I'll be the first to admit that many stocks drop 25% and turn out to be bad investments. That can happen with a business that has no real competitive advantages to begin with. Or, as happened in the financial sector, when once-respected companies make some baffling decisions. Some come back, like Goldman Sachs (NYSE:GS); some don't (AIG (NYSE:AIG)).

Lesson learned
We've all learned some things throughout the years. But if, as Tom Gardner says, you can invest for decades, add money to your existing holdings steadily over time, and stay committed to focusing on truly great businesses, you stand to make a fortune.

In the six years since Stock Advisor was launched, Tom and David Gardner's recommendations have outperformed the S&P 500 by an average of 40 percentage points. Interested in finding out which stocks to start with? Start up a no-obligation 30-day free trial, and you'll see Tom and David's five best buys for new money right now. Here's more information.

This article was originally published on Jan. 8, 2007. It has been updated.

Rex Moore lathers and rinses, but never repeats. Of the companies mentioned in this article, he owns shares of Microsoft. UnitedHealth Group is a Motley Fool Stock Advisorrecommendation. Microsoft and UnitedHealth Group are Inside Value selections. The Fool owns shares of UnitedHealth Group.  The Motley Fool has a disclosure policy.