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 the market activity that led to the recent volatility showed that in good times, many investors are willing to chase returns without regard to risk. This strategy -- let's call it the "more risk, more reward" school -- has finally showed that it 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 is always among the most heavily traded tickers. 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 BEA Systems
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 Yahoo!
Yahoo! just rebuffed Microsoft's generous buyout bid, and CEO Jerry Yang wrote in a memo today that the $44 billion offer "substantially undervalues" the company. So why all the volume? Investors are looking to make a quick buck on the bet that Microsoft revises its offer higher. Of course, if Microsoft chooses to walk away, that will be a bet gone wrong.
IDM is an even more speculative situation. The tiny $56 million drug developer released some promising data on its bone-cancer drug, and the market has been selling it up and down ever since. This isn't a durable business -- it's a lottery ticket.
While these are different situations, what they have in common is that the investors here are all trading based on speculation or news. In a market with a longer view, these wouldn't be two of the market's most popular stocks.
But more risk, more reward, right?
Here comes the punch line
The truth is, however, that investors don't need to be taking these risks 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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This article was first published on April 24, 2007. It has been updated.