Modern portfolio theory holds that investors are rational, risk-averse folk. That means if we're presented with two investments that offer the same rate of return, we'll opt for the one less likely to lose money.
Yet recent market activity indicates that many investors are willing to chase returns without regard to risk. Let's call this the "more risk, more reward" school -- and it can lead to crippling losses.
Putting theory in practice
Take a look, for example, at the lists of the most heavily traded stocks on any given morning. The Nasdaq 100 exchange-traded fund almost always leads the way. That's because, since it's a volatile and liquid issue, it's ripe for rapid trading. And many investors attempt to take advantage. There's simply no other reason why an index that tracks Research In Motion
But as studies from Malkiel, Siegel, and many others have shown, the market is unpredictable over short periods of time. Investors who attempt to predict minute-by-minute changes in the market are taking an enormous risk with their capital -- and they're not being adequately compensated for it.
But more risk, more reward, right?
Little upside, tremendous downside
Go a little further down the most-actives list today and you'll see Sonus Networks
These companies all have price-to-earnings (P/E) ratios greater than 40 -- and Sonus is trading for more than 120 times earnings! While the P/E is admittedly a rough measure, it's my short way of showing that these probably shouldn't be three of the market's most popular stocks. None bear any resemblance to the 10 best stocks of the past 10 years.
But more risk, more reward, right?
More signs of the risk apocalypse
Then there was this ominous headline in The Wall Street Journal recently: "'Blank Check' Firms Gain Favor." A blank check firm, also called a special-purpose acquisition company (SPAC), is a business-less entity that "promises to buy a business" with the proceeds of its IPO.
In other words, SPAC investors have no idea what they're buying into.
But this minor detail hasn't stopped SPACs from becoming extremely popular. According to the Journal, a record 17 SPACs went public in the first quarter, and the 20 that IPOd through April raised more than $2 billion. That's $2 billion invested in nothing more than a glitzy presentation.
But more risk, more reward, right?
Here comes the punch line
The truth, however, is that investors don't need to be taking these risks in order to make serious money in stocks. Indeed, as Mohnish Pabrai wrote in his book The Dhandho Investor, the investors who succeed for decades are those who consistently buy into situations where the range of outcomes is confined to "Heads, I win; tails, I don't lose too much."
The Foolish bottom line
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Tim Hanson does not own shares of any company mentioned. Amazon.com and Electronic Arts are Motley Fool Stock Advisor recommendations. The Fool's disclosure policy boggles the mind.
