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
For example, look at the lists of the most heavily traded stocks on any given morning. The Nasdaq 100 exchange-traded fund almost always leads the way. 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 KLA-Tencor (Nasdaq: KLAC), Autodesk (Nasdaq: ADSK), Apollo Group (Nasdaq: APOL), Leap Wireless (Nasdaq: LEAP), and 96 other popular 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 the most-active list today, and you'll see some other interesting trends. Today, for example, Washington Mutual (NYSE: WM), Annaly Capital (NYSE: NLY), and Countrywide Financial (NYSE: CFC) all crack the upper echelon.

Each one of these financial firms has encountered some trouble thanks to subprime mortgage exposure and/or the tightening credit market. But all are jumping on the news that the Fed would extend its temporary lending program. What each of these situations has in common is that the investors here are trading based on short-term news. In a market with a longer view, there might still be reason to have some concerns.

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 19 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. Washington Mutual and Annaly Capital are Income Investor recommendations. The Fool's disclosure policy boggles the mind.