Where can you get the best return on investment in the stock market? We are not talking about short term gains followed by abrupt losses but long term growth. Maybe, low priced, low grade stocks bundled up in index funds are the way to go. Thirty and more years ago stock market research revealed that, on the average, lower grade stocks outperform the blue chips over time. But, research showed that you needed to have at least 40 stocks to balance out the risk.
Now, with indexed funds based on this pool of stocks, you can tap into the long term growth of a pool of low grade stocks and get your best return on investment of all of your investments.
Why in the world would you want to invest in low priced, low grade stocks? You spend your available time looking for quality stocks to get long term growth and your best return on investment.
The answer lies in the fairness of pricing of the US stock markets and relative risk. Because of the relative transparency of the US stock markets there is a lot of attention to companies by a lot of people. With lots of research and a fluid market, prices tend toward the most accurate reflection of a company’s value for the day. Stock prices also correct themselves rapidly. Thus the price of a stock is the consensus of a lot of information and is a fair representation of the stock’s value and risk.
The risk is the other part. We know that start up companies and companies that have lost value because of management problems are low grade stocks with less chance for the best return on investment and long term growth. We also know that within the group will be the next Microsofts, Intels, and Genentecs. In order to cash in on the best return on investment with these eventual blue chips you need to be there at the beginning. But, which stock will make it and which ones will go bankrupt?
Because of the risks in investing in low grade stocks, investors demand a higher rate of return. Thus investors pay less per stock in order to balance the risk in low grade stocks. Thus, with time and a sufficient pool of stocks to balance risk low grade stocks give the best return on investment over the long term.
Before index funds one could buy forty randomly selected low grade stocks and replace the ones that went bankrupt as one waited for a couple to emerge with great long term growth and the best return on investment in the market.
Because we pay less for low grade stocks we balance the risk of low grade stocks. But, it is best to have a large pool. Forty, according the research, is the low number. It is better if you buy into a larger pool of low grade stocks. Then the odds work for you and you will end up with long term growth and, probably, the best return on investment in your portfolio.
The interesting part of this theory is that it is based upon the transparency of the market and the fairness of pricing. The theory says that you pick low grade stocks solely based upon price and condition depending upon the market to provide long term growth. Too much stock picking by fund management runs against theory and may give you lower returns!