When Stocks Crash

Investing in Rule Breaker stocks -- the kind of companies that could fly to the moon overnight, the businesses that have the potential to change the world and make shrewd investors rich in a very short period of time -- can really suck.

Yes, there's something to be said for owning a piece of Vertex Pharmaceuticals and watching with a smug grin as it has increased in value more than 300% in a year. The reason for that gain? Not anything tangible like profits or cash flow, but rather the promising performance of its VX-950 hepatitis C protease inhibitor in clinical trials.

But the flip side can be undeniably painful.

Stupid Shanda!
Shanda (NASDAQ:SNDA) is a leading purveyor of massively multiplayer online role-playing games in China. When Rule Breakers advisor David Gardner recommended it in the January 2005 issue, it made sense to me. I bought the premise -- online gaming for a huge country rapidly ramping up its technological buy-in -- and then I bought the stock. It's tanked since then, down more than 60%, and early last week was about the peak of its crappiness. In one dreadful day, it dropped approximately 20% in share price, dinging my portfolio and opening me up for workplace ridicule in the process. Not good times.

The facts of life
Yet I recognize that volatility among growth stocks is a fact. And while some drops are buying opportunities, companies never recover from other drops. Here's a small sampling of stocks that survived the bubble's aftermath:

Let's just say you'd be a lot happier having sold Gateway and doubling down on Apple or Akamai than you would be the other way around. And price would not have made a dime's worth of difference when making the decision -- only an analysis of the business, its strategy, and its prospects would do that.

In 2002, Apple's long history of making innovative consumer products was helping the iPod gain traction. Cisco had a leading market share in networking. Akamai was well positioned to deliver content over the Internet. Meanwhile, Gateway's direct sales were slowing down around the turn of the century, and its decision to open nearly 200 stores did not create the kind of growth it needed to keep up with Dell, which was stealing market share. Hindsight is 20/20, but it's easy to see why these companies survived and Gateway is still struggling.

So should I sell Shanda?
As I watch Shanda's share price trickle downward, I had to remind myself that despite the short-term pain, I'm a buy-and-holder. I'm in this for the very long haul -- most of my Rule Breakers selections were purchased on behalf of my 2-year-old daughter, and she's not going to need that money until she decides to remove those ill-conceived tattoos she's bound to get in college to prove something to me.

In other words, I can wait Shanda out. But the company is on a short leash. In the most recent conference call, management described its new "free-to-play" model, which is designed to increase players, get them hooked, and then upsell bells and whistles to them. The company also claims to have some strong products in the pipeline.

It is beta-testing an instant-messaging system called QuanQuan, planning a real-world hardware gaming console, expanding online offerings in non-gaming content through collaborations with dozens of content providers, and improving its advertising-driven search tools in collaboration with Baidu (NASDAQ:BIDU). Given the sell-off last week, investors seem to be skeptical. We'll see.

Or should I buy more?
I'm fully aware that I can't time the bottom when picking stocks, but doubling down on out-of-favor offerings can make you wealthy, when you reinvest in the right companies. And while I tend to have faith in my companies, it's worthless to throw good money after bad. So I hold on in a case like this. I don't think Shanda is as well positioned as Akamai or Cisco was in 2002, but on the other hand, it appears to be in better shape than Gateway. I'd like to see some positive results from the pipeline and some promising data from the "free-to-play" model before I commit more capital to the company.

The Foolish bottom line
Rule Breaker investing might make you a bit sick to your stomach as it's happening -- as I said, this kind of investing can suck -- but David Gardner and his team have taken advantage of temporary dips more than once to help build a scorecard that is up more than 28%, compared with the S&P 500's climb of just 6.4% over the same period. To see their stock picks, be our guest at Rule Breakersfree for 30 days.

Doubling up on stocks hitting a lull has proved to be about my most successful investing trick. As for Shanda, we'll see.

Roger Friedman knows a breast pump when he sees one. He is the author of Nipple Confusion, Uncoordinated Pooping and Spittle: The Life of a Newborn's Father . He (and his rapidly growing family) own shares of Shanda and Vertex. Akamai is a Rule Breakers recommendation. Dell is a Stock Advisor and Inside Value pick. The Motley Fool isinvestors writing for investors.