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 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 Bed Bath & Beyond (Nasdaq: BBBY), Intel (Nasdaq: INTC), Logitech (Nasdaq: LOGI), SanDisk (Nasdaq: SNDK), and 96 other big names 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 Friday's most-actives list and you'll see E*Trade (Nasdaq: ETFC), Countrywide Financial (NYSE: CFC), and the Financial Select Sector SPDR (AMEX: XLF).

Each one of these issues is tied closely to the credit market crunch, and I don't doubt that speculators are trying to play the momentum game to ply quick gains. After all, none of these names 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 of this year, 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
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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 nearly 30 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. Bed Bath & Beyond and Intel are Motley Fool Inside Value recommendations. Bed Bath & Beyond is also a Stock Advisor pick. The Fool's disclosure policy bottles the mind.