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 -- has now been proved to lead to crippling losses.

Putting theory in practice
Yet, even after watching the demise of the investment bank this year, market participants still haven't committed to being unleveraged, long-term, business-focused investors.

Take a look, for example, at the lists of the most heavily traded stocks on any given morning. The Nasdaq 100 and SPDR (AMEX: SPY  ) ETFs almost always leads the way. That's because -- since they are volatile and liquid issues -- they're ripe for rapid trading. And many investors attempt to take advantage. There's simply no other reason why a pair of indexes that track giant companies such as Yahoo! (Nasdaq: YHOO  ) and Google (Nasdaq: GOOG  ) , and Exxon (NYSE: XOM  ) and Johnson & Johnson (NYSE: JNJ  ) 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 a number of leveraged ETFs, such as Ultra Financials Pro (NYSE: UYG  ) , Ultra S&P 500 (NYSE: SSO  ) , and Ultra Short S&P 500.

As investment banks discovered this year, leverage is a dangerous game. Yet even a global economic collapse hasn't been enough to temper the appetite for these leveraged products.

But more risk, more reward, right?

Here comes the punch line
The truth is, investors don't need to be taking these risks to make serious money in stocks. Indeed, though Mohnish Pabrai has had a terrible year, his advice in The Dhandho Investor is sound: To invest successfully for the long term, consistently buy into situations where the range of outcomes is confined to "Heads, I win; tails, I don't lose too much."

That's an overriding principle at our value-focused Motley Fool Hidden Gems small-cap investment service, where 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.

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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. Google is a Motley Fool Rule Breakers recommendation. Johnson & Johnson is an Income Investor pick. The Fool's disclosure policy bottles the mind.


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  • Report this Comment On March 20, 2009, at 5:54 AM, easyrob wrote:

    I'd like to ask, If you believe that right now is a great time to invest in stocks (headline from MF) for the Long run then why would buying a leveraged long ETF (like SSO) be a bad thing during these times when valuations are low, as reported by the MF?

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