Why Great Companies Can Be Terrible Investments

It seems like we’ve all heard the old saying, “nothing ventured, nothing gained.” It’s a bit of a cliché, but it holds a crucial truth, especially when it comes to your money. This idea is the foundation of one of the most important concepts in finance: risk. For anyone just getting into , understanding this relationship is everything.

Markets are incredibly efficient. They have to be. In a logical world, riskier assets must offer a higher return to convince anyone to buy them. If a safer asset offered a better return, everyone would flock to it, and no one would touch the risky one. Economists call this a “free lunch,” and they’re incredibly rare.

Imagine if a corporate bond paid a lower interest rate than a U.S. government bond with the same maturity. It wouldn’t make sense. The government bond has virtually no risk of default, while the corporate bond always has some. Investors would immediately sell the corporate bonds (driving their prices down and yields up) and buy the government bonds (driving their prices up and yields down) until the balance was restored. The market automatically prices assets to compensate for their perceived risk. This is the core of : taking calculated risks in exchange for potential rewards.

The Risk You Get Paid For (And The Risk You Don't)

So, if you’re looking for high returns, should you just find the riskiest company out there and buy its junk bonds? Not exactly. Doing that exposes you to a type of risk that the market reward you for.

Economists call this . It’s the danger of putting all your eggs in one basket. That single company might go bankrupt, and you could lose everything. The smart move is to diversify by, in effect, buying the bonds of all the companies within that same high-risk category. This eliminates the company-specific risk that can be avoided.

The risk that’s left over—the kind that can’t be diversified away, like the general risk of owning stocks—is called . This is the risk the market actually pays you to take. A solid strategy is built on taking on compensated risk while minimizing uncompensated risk through broad diversification.

The "Sleep Well" vs. "Eat Well" Approach

Looking at historical data makes this relationship crystal clear. Between 1926 and 2003, ultra-safe one-month Treasury bills gave investors a real return (after inflation) of less than 1% per year. U.S. government bonds, which have interest-rate risk but no credit risk, did a bit better at around 2% per year.

Meanwhile, the S&P 500, a broad measure of the stock market, delivered an annualized return of over 7% after inflation.

Of course, those higher stock market returns weren’t guaranteed every year. There were brutal downturns that tested even the most disciplined investors. This highlights a key difference. Those who keep their money in cash or cash-like savings might sleep well at night, but it’s the long-term investors who risk their capital in equities who are far more likely to eat well. Effective means knowing when to prioritize sleeping well (emergency funds) versus eating well (long-term growth).

This brings us to a critical distinction: savings versus investments. Your savings are for emergencies and short-term goals, like a down payment on a house. Once that safety net is in place, the rest of your capital should be invested for the long haul.

Why Great Companies Can Be Terrible Investments

Here’s where things get counterintuitive. If you want to build a winning portfolio, which stocks should you buy? Most people would instinctively say you should buy the stocks of “great” companies—the ones with amazing products, strong balance sheets, and stellar reputations.

But that’s usually the wrong answer.

Let’s imagine a little experiment. It’s December 1963. John is the best stock analyst in the world. He correctly identifies the companies that will have the highest return on their assets over the next four decades. Believing that great companies make great investments, he builds a portfolio of these star performers.

Jane, on the other hand, believes markets are efficient. She thinks that if a company is widely seen as "great," its stock price will already be bid up so high that there’s little room left for high future returns. So instead, she does the opposite: she buys a passively managed portfolio of “lousy” or “value” companies—the distressed ones trading near their liquidation value.

Fast forward 39 years to 2002. Who was right?

John’s analysis was perfect; his great companies produced a return on assets of 9.1% per year, more than double the 4.2% from Jane’s lousy companies. But when it came to investment returns, Jane’s portfolio of value stocks delivered an average annual return of 15.5%—crushing John’s 10.1%.

The market already knew John’s companies were great, so it priced them for safety, leading to lower expected returns. Jane, however, was compensated for taking on the perceived risk of owning struggling companies. The same holds true for small companies, which historically have outperformed large companies for the same reason: they are perceived as riskier. This is a vital lesson for : the price you pay is just as important as the quality of the company.

Building Your Portfolio's Safety Net

This focus on risk doesn't mean you should put 100% of your into small, struggling companies. You also need a safety net, which is the role of fixed-income assets, or bonds, in your portfolio. Their main job isn't to generate massive returns but to provide stability when the stock market gets rocky.

Just like with stocks, trying to actively manage bonds by guessing interest rate moves is a loser’s game. The winning strategy is to buy and hold. But which ones?

Research shows that the extra return you get for owning longer-term bonds diminishes significantly after about five years. Extending a bond’s maturity from five to twenty years historically hasn’t added to returns but has nearly doubled the volatility. Worse, longer-term bonds tend to have a higher correlation with stocks, meaning they can fall at the same time—exactly when you need them to hold steady.

For most investors, the smartest move is to stick with very short-term (one- to two-year) fixed-income assets of the highest quality. They have low volatility and almost no correlation to the stock market, making them the perfect portfolio anchor. While you can explore with different assets, the primary role of bonds in a growth portfolio should be safety and diversification.

Tying It All Together

At this point, you have the core principles of a winning investment strategy. Markets are efficient, and they reward you for taking on compensated risk.

• If you want higher returns, you must accept more risk. This means favoring equities over bonds.
• Within equities, the highest expected returns have historically come from riskier asset classes, like small-cap stocks and value stocks.
• Trying to pick individual winners is a losing game. The best approach is to own passively managed funds that hold entire asset classes.
• For the stable part of your portfolio, use short-term, high-quality bonds to reduce volatility and provide a safety net.

Understanding isn't about finding secrets or "beating the market." It’s about understanding how markets work and aligning your strategy with that reality. By embracing risk intelligently, you can let the market work for you.