Why Great Companies Often Make Poor Investments

When it comes to investing, one of the most common sayings you’ll hear is, “Nothing ventured, nothing gained.” It’s a simple phrase that perfectly captures the most important factor in building a successful investment strategy: risk. For anyone exploring , understanding this relationship is the first step. The core idea is that markets are efficient, meaning riskier assets have to offer higher returns to convince anyone to buy them.

That word, “expected,” is key. If the higher returns were guaranteed, there would be no risk. Sometimes, the risk materializes, and the actual results don’t live up to the initial expectations. Imagine a scenario where a U.S. government bond, which has virtually no credit risk, offered a higher yield than a corporate bond with a similar maturity. It just wouldn’t make sense. The corporate bond has some level of default risk, so it must offer a higher yield to attract investors. If that strange situation ever occurred, people would rush to sell the corporate bonds and buy the government ones, and their actions would quickly restore the natural order. This constant balancing act ensures investors are fairly compensated for the amount of risk they take on when .

The Real Meaning of Risk

We already know that companies have to pay more to borrow money than the U.S. government does. We also know that companies with poor credit ratings have a higher cost of capital than those with strong ratings. Here’s the flip side of that coin and a vital piece of the puzzle: a high cost of capital for a company translates into a high expected return for the people providing that capital. This is a fundamental concept in .

So, why not just find a company with a junk bond rating and put all your money there? Because you might just pick the one that goes bankrupt. That’s what’s known as “uncompensated risk”—the risk of owning just one or a few securities within a certain risk category. You’re taking on the risk that can be diversified away, but you’re not getting any extra expected return for it. To eliminate this, you need to own all the companies within that asset class. The risk that’s left over, like the general risk of owning stocks, is called “compensated risk” because the market does reward you for taking it.

Looking back at data from 1926 to 2003, the evidence is clear. One-month Treasury bills gave a real return of less than 1% per year after inflation. U.S. government bonds, which have interest-rate risk, did a bit better at around 2%. But the S&P 500 Index, representing the broader stock market, delivered an annualized after-inflation return of over 7%. Those higher returns weren't guaranteed every year—there were plenty of rough patches. But the potential for higher returns is why savers who keep their money in cash might sleep well, while disciplined, long-term investors are more likely to eat well.

Savings Are Not Investments

This brings up an important distinction for anyone figuring out . Savings and investments serve different purposes. Savings are for emergencies, cash flow needs, and short-term goals like a down payment on a house. Because this money needs to be safe, it sits in low-risk, low-return places. Once you have that safety net, the rest of your capital can be invested for long-term growth. The right mix of savings and investments is different for everyone and depends on your timeline and how much risk you can stomach.

Finding Assets with High Expected Returns

So if equities have historically provided higher returns, how do we find the ones with the expected returns? The answer is surprisingly simple: you look for the riskiest ones. In the world of , that generally points to two categories: small companies and what are often called “value” or “lousy” companies.

“Value” companies are businesses trading at a price close to their liquidation value, often identified by a high book-to-market ratio. Investors have driven their prices down because of poor track records, high debt, or shaky earnings. Small companies are also seen as risky because they have less access to capital to weather economic storms and don’t have the long, proven track records of larger corporations. They also tend to get less attention from analysts, creating more uncertainty for investors. As companies like Microsoft and Citigroup grew larger and safer, their cost of capital went down, and so did their expected future returns for new investors. This isn't a bad thing; it just means that lower risk comes with lower expected rewards. This is a core lesson when .

The Great Company Myth

This leads to a conclusion that feels wrong but is backed by decades of data: great companies don’t necessarily make great investments. Imagine two investors back in 1963. John is a brilliant analyst who correctly identifies the companies that will have the best financial performance over the next 38 years. He builds a portfolio of these “great” companies. Jane, on the other hand, believes markets are efficient. She buys a passively managed portfolio of “lousy” value companies, expecting that the market will reward her for taking on more perceived risk.

Fast forward to 2002. John was right about the companies—his portfolio’s return on assets was more than double Jane’s (9.1% vs. 4.2%). But Jane was right about the investments. Her portfolio of value stocks delivered an average annual return of 15.5%, far outpacing the 10.1% return from John’s great growth stocks. The market had already priced in the high expectations for the great companies, leaving little room for high returns. A similar pattern holds for small companies versus large companies. The market works by rewarding risk.

Think about it in terms of . You’re looking at two properties. Property A is in a prime commercial district, and Property B is next to the worst slum in town. If they were both priced at $10 million, everyone would buy Property A. In the real world, the price would adjust. Property A might sell for $30 million and Property B for $4 million. At these prices, Property B has to offer a much higher expected return to compensate an investor for its risk. It’s not a worse investment, just a riskier one. The same logic applies when in stocks. This dynamic is one of many that can work over the long term.

A Strategy for Fixed Income

The principles of risk and return don’t just apply to stocks. When it comes to fixed-income assets like bonds, the goal for most investors is to reduce the overall volatility of their portfolio. Academic research shows that while investors are compensated for owning longer-term bonds, that extra reward diminishes significantly after about five years, while the risk continues to climb.

What's more, short-term bonds have very low correlation with stocks, meaning they are more likely to hold their value when the stock market is down. This makes them a more effective safety net. For this reason, a winning strategy for the fixed-income part of a portfolio is often to own high-quality, short-term bonds with maturities of one to two years. These form a stable base for your other .

Two excellent tools for this are Treasury Inflation-Protected Securities (TIPS) and I bonds. Both provide a guaranteed real return plus protection against inflation. TIPS are best held in a tax-deferred account, while I bonds are great for taxable accounts since taxes are deferred until you cash them out. These options help you while protecting your purchasing power.

Your Winning Strategy

Putting it all together, the path forward becomes clear. We know from that markets are largely efficient, making passive management the winning strategy. If you need higher returns and can accept the associated risk, you should allocate a portion of your portfolio to riskier asset classes like small-cap and value stocks. To balance that risk, the fixed-income portion of your portfolio should be in low-risk, short-term instruments. This approach doesn't promise to make you rich overnight, but it is a time-tested strategy for building wealth over the long haul.