Ever hear the apocryphal story of the farmhand who applies for a job? When asked about his qualifications, the farmhand replies, "I can sleep when the wind blows." Though puzzled, the farmer hires the otherwise able fellow.
The farmer is awakened by a violent storm a few nights later. Terrified by the gusting wind, cracking lightning, and rolling thunder, he jumps out of bed and frantically runs around the house. Instead of the devastation he expects, he finds the windows shuttered, the logs stacked by the fireplace, the tractor secured in the shed, and the animals warm in the barn with fresh hay. He returns to the house and finds the farmhand fast asleep. It was then that the farmhand's words made sense: As long as you're prepared for the storms that will inevitably come, and as long as you faithfully do what needs to be done each day, you can still sleep soundly when the tempest is upon you.
This strikes me as an apt allegory for small-cap stock investors. The winds that can push your portfolio up and down on a daily basis should not affect your ability to get a sound night's sleep. Prepare for the worst, and you'll find that you can sleep through the worst of the storm, just like the farmhand.
At Motley Fool Hidden Gems, we see this concern often expressed by investors who feel that small-cap stocks -- including our newsletter's 50-plus recommendations, which are currently beating the S&P 500 by 17 percentage points -- are volatile. Their bumpy rides are perhaps more than many unprepared investors can stomach.
Industrial measuring equipment manufacturer FARO Technologies (NASDAQ:FARO) was recommended to Hidden Gems subscribers in January 2004 because it was a growing leader in a niche industry. The stock has rewarded investors since then -- it's nearly doubled in value -- but it has seesawed several times along the way. It's moved from $11 per share to $32 and then down again to $20, which is about where it sits today. That kind of price action can be gut-churning.
As a remedy for that kind of motion sickness, Hidden Gems leader and Fool co-founder Tom Gardner has advocated that investors follow three basic principles for achieving a good night's sleep.
Step No. 1: Save and invest regularly
Start a regular program of saving money and investing every month. Whether it's $50 or $5,000, put aside money each month, and you'll soon find that even small amounts add up over time. Shelby Davis once remarked that "the best time to invest is when you have the money." Always adding to your savings and rarely selling your stocks is the surest way to amass a small fortune.
Step No. 2: Diversify broadly
Tom also agrees with master investors Shelby Davis, Walter and Edwin Schloss, and Joel Tillinghast, among others, who made and managed millions of dollars by owning hundreds -- if not thousands -- of stocks in their personal and professional portfolios. For investors who lack the time to become a "professional" or the requisite knowledge to know the nuances of stock analysis, broad diversification makes the most sense.
Hidden Gems analysts research and analyze dozens of companies each month in their search for two small-cap picks, three companies to keep on your watch list, and two micro-cap Tiny Gems. Over the course of a year, that's more than 80 companies to chew over for a diversified portfolio. How diverse are the companies? Here's a sampling of the businesses: Blackboard (NASDAQ:BBBB), Rimage (NASDAQ:RIMG), PacifiCare (NYSE:PHS), International Assets (NASDAQ:IAAC), and PlumtreeSoftware (NASDAQ:PLUM).
Step No. 3: Invest for the long term
Simply put, you shouldn't be investing money that you don't plan to keep in the market for at least three to five years. Minimum. In fact, Warren Buffett said that the best time to sell a stock is almost never, and he urges investors to think of themselves as business owners. Thinking like an owner -- not a trader -- gives you a frame of reference for making sound investment decisions.
Not only that, but the buy-and-hold mentality reduces your transaction costs and taxes and can improve your returns. Peter Lynch noted that it was usually by the fourth year of stock ownership that he started to see his investments fully appreciate. Consider that a year after its recommendation, Hidden Gems pick CNS (NASDAQ:CNXS) was selling for less than when it was recommended. But another year later and it had tripled in price, and the business fundamentals continue to be solid.
At Hidden Gems, we seek out the companies we think will be tomorrow's leaders. We look for companies that are profitable and generate cash, and that have owners who think like their investors. If you'd like to join us in the hunt, you can test-drive the service for free with a 30-day trial membership. You'll have access to the recently released six-month review, which will bring you up to speed on every company we've recommended (we even ranked our current favorites for new money).
Such broad coverage and deep analysis will allow you to sleep easily at night, even through the worst of market storms.
Fool contributor Rich Duprey does not own any of the stocks mentioned in this article. Blackboard is a formal Hidden Gems recommendation. The Fool has adisclosure policy.
