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 ETFs almost always lead the way. 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 Genzyme
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 farther down the most-actives list, and you'll see a number of leveraged ETFs, such as Ultra Financials Pro, Ultra S&P 500, 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."
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This article was first published on April 24, 2007. It has been updated.
Tim Hanson owns shares of Philip Morris International. PepsiCo. is a Motley Fool Income Investor pick. The Fool's disclosure policy boggles the mind.
