I recently had to explain to my Top Stock Advisor premium readers why I decided to color outside the lines with our most recent pick...
Normally, our goal is usually to identify elite businesses that are trading at a discount to their intrinsic value. After that, we buy them and hold "forever."
But this time was different, or so it seemed. You see, this time around the stock we were buying wasn't necessarily a long-term pick -- more of an "opportunity" trade that might last anywhere from a few weeks to several months.
But here's the reality: if you're a long-time subscriber, then you know we've been doing this for a long time. In fact, I believe these types of trades are essential for any long-term portfolio. Here's why...
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Before I go further, don't get me wrong... Our "forever" strategy has led to market-beating returns from the vast majority of our holdings. For instance, we picked up the wonderful company that is American Express (NYSE: AXP) in September 2016 after shares had significantly sold off when its relationship with Costco (Nasdaq: COST) ended (one of the first of our "crisis"-themed investments). Since then we've outperformed the S&P 500 by a whopping 65 percentage points.
The story is similar with chocolate-maker Hershey (NYSE: HSY). We picked up shares of this world dominator when they were trading for cheap. As I said in October 2018 , the "last time Hershey traded for this cheap it soared triple-digits." And while we aren't up triple digits (yet) the stock is off to a strong start in the eight months we've held it.
I could go on and on, but you get the point...
You're Not Gonna Like This Part
But here's the part that might get me in trouble...
You see, the unpopular truth about investing is that buying and holding a stock "forever" is unrealistic. In August 2017, I explained why "buy-and-hold" investing was a fallacy that gets hammered into us by Wall Street and others in mainstream financial circles.
Here's the truth... Most folks who believe they are buy-and-hold investors end up being "buy and fold" investors. Or they continue to hold onto a losing position for years just hoping the stock gets back to their entry price so they can break even.
Holding a losing investment for years is not only an emotional drain, but it costs something far more valuable than any return a stock can give you, and that's time. You can't make up for the lost time.
Time -- and timing -- can be everything when it comes to investing. If you're 18 and beginning your investment journey, you can afford to take the occasional lumps inherent in the buy-and-hold strategy. If you buy a great company, you have the time to weather the storms and enjoy compounding returns.
But many of us no longer have that luxury. We don't have the time to recover from a severe bear market. Just ask the buy-and-hold investors nearing retirement in 2008, when some of the world's greatest companies saw massive drawdowns.
For example, American icon Coca-Cola (NYSE: KO) suffered a 40% drawdown during the financial crisis. And it would be nearly three years before shares would recapture their previous highs.
Sure, it's easy to look back and see that had investors held firm their portfolios would recover... eventually. But few people can tolerate those sorts of drawdowns.Try telling someone nearing retirement that he will have to postpone his golden years for a few more years. That will be the longest three years of his life.
Just recall how you reacted when the market saw a near 20% pullback in December. Now multiply that roller coaster ride times three years. Many of us would (and did) get off the ride altogether.
Even Warren Buffett, arguably the world's greatest investor, and the man who says his favorite holding period is "forever," understood that you can't build a portfolio strictly on long-term, "forever stocks." When he managed money for other people through the Buffett Partnerships in the 1950s and 1960s, he didn't put all their money into long-term investments.
Keep Your "Forever Stocks," But Do These Two Things Right Now
While Buffett is famous for his steadfast patience in many of his holdings -- such as Geico, Coca-Cola and American Express -- he also carved out a chunk of his portfolio for opportunities he expected to pay off in a shorter time frame (from a few months to a couple of years).
He also makes sure he has a good chunk of cash on hand to pounce on opportunities as they arise. Buffett's holding company, Berkshire Hathaway (NYSE: BRK.A) has more than $114 billion in cash.
I believe that these two portfolio characteristics -- dedicating part of your portfolio to investments with a shorter time frame and keeping plenty of "dry powder" on hand -- provide you with two very powerful advantages.
First, shorter-term investments typically can provide an added boost to your portfolio and are uncorrelated to the broader market. These are opportunities that are intended to greatly outperform the broader market -- sooner, rather than later.
Our position in Okta, Inc. (Nasdaq: OKTA) over at Top Stock Advisor is a great example of this. This isn't an enterprise that carries the typical traits that you might see in a world-dominating company. It doesn't turn a profit or reward shareholders with increasing dividends. It's a growth stock that operates in the burgeoning and increasingly important cybersecurity space.
In the year that we've held Okta, we've greatly outperformed the broader market...
The second advantage of having part of your portfolio dedicated to shorter-term opportunities is that it recycles capital quickly -- allowing you to buy elite businesses at a discount to their true value in the event of a market downturn.
If your portfolio is filled with only long-term investments and the market crashes, what would you sell to free up the needed cash to buy wonderful businesses that might be trading at 50% of their true value?
Action To Take
Look, I want to be clear: I'm not changing the investment philosophy of Top Stock Advisor. In fact, we've been doing this as a compliment to our "forever" strategy the whole time.
I will continue to seek out elite companies that we can pick up at fair values. But on occasion, I might color outside the lines. If I see an opportunity in a stock that might not carry the characteristics of a "forever" stock but does present an attractive risk-reward setup, I'm going to pull the trigger.
With each of these "speculations," I will go in with a plan. I will know the downside risk before I go into the investment. I will have a certain downside price threshold that will tell me if my investment thesis is wrong or my timing is off. This will limit my downside risk... because the upside potential is tremendous.
You should consider doing the same.
(This article originally appeared on StreetAuthority.com.)