The Most Effective Stock Strategy of All

If I told you that there's an investing strategy -- a portfolio management strategy, really -- that can greatly enhance your returns over time and doesn't cost anything but a little time to implement, would you be interested?

It gets better: This strategy is rooted in a simple mathematical concept -- so simple that my seven-year-old son understood it in seconds. Now, he's kind of a math whiz as seven-year-olds go, but still. He's seven.

And yet many people who consider themselves expert investors -- including many Wall Street pros -- seem ignorant of this simple, basic concept.

What's the concept? Ponder this: If you have an investment that goes up 50%, and then down 50% (or vice versa), you've lost money.

Dude, that's not an investing strategy
Not by itself. But it's a way to express the principle behind the investment strategy I'm talking about, which could be summed up this way: Always sell your losers.

Obviously people don't like to recognize losses -- "loss aversion" is actually a well-known and well-studied psychological principle, part of the basic wiring of the human brain. Selling a stock that's down from where you bought it makes you wince, doesn't it?

But here's the thing: A lot of losing stocks go on to become big losers -- many more than would be attributable to random chance, according to an analysis by noted hedge-fund researcher Eric Crittenden. And even many stocks that take less dramatic falls are likely to underperform the major indices over time, he says.

In fact, Crittenden says that some 39% of Russell 3000 stocks were unprofitable for shareholders between 1983 and 2006. That's not a little growth that lagged the index, that's no growth. According to Crittenden, a minority of stocks -- 25% of the market -- were responsible for nearly all of the overall market's gains over that period.

So in other words, as Crittenden sees it, the path to success is to own the moneymakers and not the losers. That means identifying the losers and -- this is the key to the strategy -- selling them in a disciplined way when they become apparent in your portfolio.

Want an example? Consider General Electric (NYSE: GE). GE's share price was absolutely crushed by the financial panic, hitting a low below $7 in March of last year. Judging from comments I've received from readers over the last year, quite a few of you saw that period as a great opportunity and bought, seeing nice profits as shares rose to their current level -- around $18.

That's great -- and if you're among those folks, you're probably not thinking of selling right now. But what if you'd bought GE in, say, October 2007, when it was trading around $40? You'd have been clobbered last March. You'd still be down over 50%, and you might have to wait a long time for the stock to "come back" to the price you'd paid -- to break even on a two-plus-year investment.

And here's what Crittenden would say: Sell. Sell, and buy something that's more likely to go up more dramatically.

Something that will go up dramatically? Like what?
Crittenden's research has shown that the highest-performing stocks are those that repeatedly make new highs. That sounds like a tautology, but repeatedly is the key to Crittenden's insight: If you buy a stock that just made a new three-year or five-year high, Crittenden says, your odds of buying a stock that will make more new highs are greatly improved. Buying stocks that have just hit highs sounds counterintuitive, but it can be a winning strategy.

Think there are no new five-year-highs out there in the wake of the market crash? Think again. I just did a screen for new ones and came up with a bunch of stocks that had hit new highs during Tuesday's trading, including these:

Source: Thomson Reuters, Motley Fool CAPS.
NM = not meaningful. *Went from loss five years ago to profit currently.

Note the relatively low CAPS ratings on these -- not what we normally look for in buy candidates. Those might be a sign of underlying troubles at these companies, or it might just be evidence of conventional wisdom asserting itself -- many (maybe even most) investors think of a new high as a sell signal, rather than a buy signal. But Crittenden would argue -- compellingly, I think -- that that sort of thinking is why so many investors underperform the market averages.

Either way, we'd need more research on those stocks before buying. But long story short, the essence of Crittenden's strategy is to hold winners tenaciously and cut losers ruthlessly -- before they can do serious damage.

But how do I know to sell before the losses get huge?
That's a little more complicated -- though not hard to implement in an in-the-ballpark way -- and I'm out of space. But no worries: Foolish retirement guru Robert Brokamp did a lengthy interview with Crittenden that appears in the new issue of Rule Your Retirement -- if you've read this far, it's well worth reading the whole thing.

Rule Your Retirement is a paid service, but if you're not a member and you'd like to read the interview, just help yourself to a 30-day trial membership with our compliments. It's completely free of charge and there's no obligation to subscribe. Just click here to get started.

Been waiting for the right moment to take action? Dan Caplinger says time's running out on a great opportunity.