How to Prevent a 25% Drop

Ever since we were introduced to Rex Moore's friend Charlie, I've been thinking about ways Charlie could have held on to the multibagger he lost when he sold Microsoft too soon. See, Charlie couldn't stand the stock market's short-term volatility, and after he saw a paper loss of nearly 25% in his Microsoft shares after only a few weeks, he bailed.

Of course, he now sorely regrets that decision.

Stock, meet company
So how could Charlie have kept the faith in his stock? Not to knock Charlie, but for a rational actor, it should have been easy. Microsoft was growing revenue at a near-30% clip, had $4.7 billion in cash and no long-term debt, was generating free cash flow up the wazoo, and was trading at only a slight premium to the market average. Moreover, this was a $45 billion company. Its chances for bankruptcy ranged from slim to none.

That said, the market is a volatile place, and stock prices often move without regard for the quality of the underlying business in the short term. If Charlie couldn't stand the volatility that comes with investing in a healthy large cap such as Microsoft, how could he ever buy to hold any of the market's 10 best stocks -- all of which began their runs as exceedingly volatile micro caps?

Wild stocks, wild returns
This question is of particular interest to me because I recommend Tiny Gems -- companies capitalized at $200 million or less -- for our Motley Fool Hidden Gems small-cap investing service. And those recommendations come with a disclaimer: "These companies are too small to be official Hidden Gems, but we think they are potential big winners. Micro caps can be excruciatingly volatile, so tread at your own risk."

Interested?

You should be. Every portfolio should have at least some exposure to micro caps because, historically, they offer the market's best returns. But these stocks can be volatile -- excruciatingly volatile -- so many investors take a pass.

Beat on the beta with a baseball bat
That said, there are ways to limit volatility and give yourself the stomach to invest in Tinies. First, hold a portfolio that's diversified across market caps and industries. One way to do this is to anchor your portfolio in a broad-market index fund such as Vanguard Total Stock Market (VTSMX) -- a low-cost option that holds more than 3,600 names and includes heavy exposure to stalwarts such as Microsoft, JPMorgan (NYSE:JPM), and Cisco Systems (NASDAQ:CSCO). Thus, when your micro caps inevitably dip and dive, the effect on your portfolio will be muted by the relative stability of your index.

But here's another way to limit volatility that I came across recently in an essay by master money manager Ron Muhlenkamp. It's a particularly appealing strategy because it would have helped Charlie keep his Microsoft shares without watering down his returns across thousands of stocks.

The secret
Just don't price your stocks so often.

That's right. Stop checking your stock quotes on an hourly, daily, weekly, or even monthly basis. As Muhlenkamp shows in his essay, market volatility is dramatically reduced when returns are considered over longer time frames. For example, take a look at how volatile these "volatile" stocks (so dubbed because they have betas greater than 1.5 or, in EMCOR's case, a two-year beta greater than two) would have been had you only checked their stock prices at the beginning, middle, and end of 2006:

Looking at it that way, the stock market isn't such a volatile place after all.

The Foolish bottom line
At Motley Fool Hidden Gems, we encourage subscribers to buy stocks with a minimum holding period of three to five years. This doesn't mean that we won't sell a stock before then if something goes awry with the business, but we will never sell based on a stock's short-term volatility. That's because we focus on finding small businesses that are well-managed, reasonably priced, and poised to take advantage of a wide market opportunity.

To date, our results are promising: We're beating the market by 28 percentage points on average. I encourage you to join Hidden Gems free for 30 days, take a look at the small- and micro-cap stocks we're recommending, and consider adding some of them to your portfolio. The volatility may not be for you, but you can change that simply by changing the method and frequency with which you look at your stocks.

This article was first published May 1, 2007. It has been updated.

Tim Hanson does not own shares of any company mentioned. Microsoft is a Motley Fool Inside Value recommendation. JPMorgan is an Income Investor pick. The Fool's disclosure policy distinctly asked for no cilantro.