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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 events prove beyond a shadow of a doubt that many investors -- including and especially the formerly well-heeled Wall Street pros -- are willing to chase returns without regard to risk. This strategy -- let's call it the "more risk, more reward" school -- has led to crippling losses throughout the entire stock market.

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 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
Now we also know that financial firms such as Lehman Brothers, AIG (NYSE: AIG  ) , Merrill Lynch, Fannie Mae (NYSE: FNM  ) , Freddie Mac (NYSE: FRE  ) , and so many more bought up exotic loans and derivative products without assessing the risks. Oftentimes these firms would use leverage to eke out a few extra points of return simply because everyone else was doing it.

Now many of these firms have gone under or been bailed out by the government. But more risk, more reward, right?

More signs of the risk apocalypse
Then there was this ominous headline in The Wall Street Journal last year: "'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 didn't stop SPACs from becoming extremely popular in 2007. According to the Journal, a record 17 SPACs went public in the first quarter of 2007, and the 20 that IPO'd through April raised more than $2 billion. Those deals have largely stopped now that the market has collapsed, but in good times investors of all stripes are all too willing to chase stocks without regard to their underlying fundamentals.

But more risk, more reward, right?

Here comes the punch line
This column isn't meant to be an "I told you so," but 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. That doesn't mean we haven't been hit hard by historic market volatility this month, but we're buying quality companies for the long term, and we know that this too shall pass.

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 -- the same tack Warren Buffett said he's following today in a recent New York Times column.

If you'd like to read all of our research, and see our favorite small caps for new money now, click here to join Hidden Gems free for 30 days. There is no obligation to subscribe.

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 Motley Fool owns shares of Bed Bath & Beyond. The Fool's disclosure policy bottles the mind.

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