How Will You Earn the Best Returns?

Modern portfolio theory holds that investors are rational, risk-averse folk. 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. This strategy -- let's call it the "more risk, more reward" school -- 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 ETF (Nasdaq: QQQQ) 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 Intel (Nasdaq: INTC), Costco (Nasdaq: COST), and 98 other giants should change hands so many times each day.

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 and you'll see Sirius Satellite Radio (Nasdaq: SIRI), Level 3 Communications (Nasdaq: LVLT), and recently, CDC (Nasdaq: CHINA), a.k.a. chinadotcom.

These companies lost more than $1.9 billion over the past year combined. While that's a meaningless statistic, it's my short way of showing that there's absolutely no reason why these should 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 IPO'd 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 is, 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 final word
No investor should be averse to making money. But we should all be averse to losing it. That's why at our Motley Fool Hidden Gems small-cap investment service, we apply bottom-up, fundamental evaluation techniques to small companies that have been overlooked by the rest of the market.

When we find a solid business that is well-managed, underpriced, and consistently able to generate cash and deploy it efficiently, we recommend that our subscribers buy shares and hold for a minimum of three to five years. We believe this strategy will help investors achieve superior returns without excessive downside risk. And our returns to date reflect our strategy -- we're beating the market by 34 percentage points, on average.

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This article was first published on April 24, 2007. It has been updated.

Tim Hanson does not own shares of any company mentioned. Intel is a Motley Fool Inside Value recommendation. Costco is a Stock Advisor recommendation. The Fool's disclosure policy boggles the mind.