If you could define the best type of stock market investment, how would you do it? Great company at a great price? All upside, no downside? The prudent way would be to define it in terms of risk and reward: low risk, high reward. Money for nothing, the epitome of investing. Let's call it Nirvana.
While Nirvana is a great place, few investment opportunities reside there. If they did, we'd all be rich. Not only do you need to be able to spot when an opportunity lands in that neighborhood, but you need to be ready to act when it does. Fortunately, The Motley Fool's Philip Durell and his Inside Value team are dedicated to identifying these rare opportunities when they arise.
The investing continuum
There are other investing locations besides Nirvana, each with its own unique topography. So using our risk/reward framework, let's get a lay of the land.
| Low Risk | High Risk | |
| High Returns | Inside-Value Investors (Nirvana) | Risk-Seekers (Xanadu) |
| Low Returns | Risk-Avoiders (Kansas) | Suckers (Hades) |
Xanadu is the home of the Risk-Seeker, an interesting character filled with self-confidence bordering on hubris. He laughs in the face of risk, knowing full well that you get more reward for taking more risk. Kansas, on the other hand, where Risk-Avoiders live, is a much different place. Risk-Avoiders are so afraid of losing money that they sacrifice returns in order to sleep at night (they're also overly afraid of houses falling from the sky). And then there is Hades, a truly frightening and dreadful place. Denizens of this fiery locale haven't a clue that they will never be compensated for the risks they are taking.
To see where you reside, here's a little test. You are offered two investment opportunities. The first one goes up 40% in year one and down 20% in year two. The second investment goes up 20% in year one and is flat in year two. The two-year pattern for each scenario repeats itself for 10 years.
So what would you choose? Don't read on until you have chosen your answer (when you are finished you may put your pencil down).
Paradise lost
At first glance, the Risk-Seekers may appear to be aggressive investors who look for big returns, especially when using a long time horizon. The lure of Xanadu is very powerful, causing many investors to miss some subtle psychological snares.
The first trap is what Charlie Munger, vice chairman and psychoanalytical guru of Berkshire Hathaway
The problem gets magnified when the Risk-Seeker monitors the rise and fall of the stocks in his group. He anxiously awaits one of them to take off. And right at that moment when the stock is poised to break out, it doesn't. The investor then experiences what Munger calls "deprival super-reaction syndrome," which can be defined as an extreme reaction to having something taken away. But the real problem arises when one stock actually does take off, departing sharply from its intrinsic value. The Risk-Seeker congratulates himself, "See. I know how to do this." Believing he has bested the market, he is now completely hooked because he has mistaken a past correlation as a reliable basis for decision-making.
What the Risk-Seeker fails to see is that if he makes a poor decision about the amount of risk taken, he goes straight to Hades. Hades is where one suffers a permanent loss of capital, along with assorted other torments.
What types of companies does the Risk-Seeker look to buy? Travelzoo
Achieving Nirvana
To obtain a Zip code in Nirvana, remember the first rule of investing: Never Lose Money. Another way to think of it is always get more than what you pay for. You can call it margin of safety or you can call it three tens for a twenty. But whatever you call it, realize that enlightened investing comes from getting more reward for less risk.
Nirvana has three benefits. First, by getting more than you paid, reversion to the mean increases the potential for good returns. Second, should you make a mistake (and believe me, we all make investing mistakes), you get to cash in your margin of safety card for a trip to Kansas instead of Hades. In other words you may not earn much, but you aren't likely to permanently lose capital. And lastly, once in a while an opportunity with huge returns pops up in Nirvana. And there you are, hopefully, ready and waiting.
What types of companies pop into Nirvana from time to time? I think Best Buy
I was more fortunate when AES
I'm hooked on value
I think the psychological process of association, whereby two ideas or sensations are connected in some way, causes many people to overlook Nirvana for two reasons. The first is because companies tend to enter Nirvana under negative circumstances. No one wants to be associated with a negative story. But the value of minimizing negative returns gets overlooked because it's human nature to focus on positive events, which, by the way, is why Option 2 outperforms Option 1 by a ratio of 2 to 1 in that test you took earlier. For those who were keeping score, here's how $10 would have performed according to each option.
| Option/Year | 1 | 2 | 3 | 4 | 5 | 6 | 7 | 8 | 9 | 10 |
| 1 ($10) | $14 | 11.2 | 15.7 | 12.5 | 17.6 | 14 | 19.7 | 15.7 | 22 | 17.6 |
| 2 ($10) | $12 | 12 | 14.4 | 14.4 | 17.3 | 17.3 | 20.8 | 20.8 | 25 | 25 |
The second reason is that value is perceived as boring. Who wants to wait around for an opportunity when you can seize one? Well, I guess I'm boring because I believe that value investing offers the only way to reside in Nirvana. If you think your portfolio might benefit from a more value oriented approach, why not try Inside Value risk-free for 30 days.
For additional insights on value, click on:
Fool contributor David Meier owns shares in AES but not in any of the other companies mentioned. The Motley Fool has a disclosure policy.
