Here are three reasons to avoid high-risk investments—and advice on buying blue-chip stocks instead

Investors often try to improve their investment returns by delving into high-risk and/or high-fee investment areas such as specialized investment products, options, penny stocks and so on.

It’s far better to start off by putting yourself in a position to profit from human nature, rather than suffering because of it, as you can often do in high-risk investments.high

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Tip #1 for avoiding high-risk investments: Stay alert for conflicts of interest

We’ve often pointed out that hidden conflicts of interest are the single-greatest risk you face as an investor. That’s because they’re everywhere, since they are a natural outgrowth of human nature. But don’t let human nature sour your view of investing. You just need to be aware of it.

After all, many companies strive to settle conflicts in favour of their customers and clients. This works out better for these companies in the long run, because it fosters customer loyalty.

Tip #2 for avoiding high-risk investments: Take advantage of spinoffs, which you may get when a company’s managers put the interests of shareholders ahead of their own.

A spinoff occurs when a company sets up one of its divisions as a separate corporation, and hands the stock out to its shareholders as a special dividend. That reduces the company’s asset base. That leaves less total corporate income to pay for management compensation, so it works against the immediate interests of management. However, it seems to work in favour of investors’ interests. Numerous studies show that over a period of years, spinoffs tend to perform much better than comparable non-spinoff stocks.

The effect also extends to the parent companies—those that carried out the spinoffs. They also tend to outperform comparable companies that have not carried out spinoffs. It goes to show, at least in this case, that striving to settle conflicts in favour of customers can pay off for companies in the long run.

Tip #3 for avoiding high-risk investments: Pay attention to stock buybacks.

When a company buys back its own stock in the market, it tends to serve the interests of its shareholders in two ways. First, it raises the company’s per-share earnings (because there are fewer shares outstanding among which earnings are divided). Second, buybacks tend to bid up a company’s share price.

You might say that buying stock back substitutes a capital gain for the dividend income you might otherwise have received if the company had used the money to pay dividends instead of buying back shares. That’s irrelevant in registered accounts such as RRSPs. But in your personal account, you may pay a lower rate of tax on capital gains than on dividends.

In any event, you are generally only liable for capital-gains taxes when you sell. You decide when that is, and you can time the sale to suit your own needs and tax situation. The longer you put off selling and paying taxes, the longer those deferred tax dollars can generate additional investment income for you. In contrast, you are liable for taxes on dividends in the year when the company chooses to pay the dividend.

Pick blue chip stocks over high-risk investments

Blue chip stocks are big, well-established, dividend-paying corporations with strong business prospects. These are companies that also have sound management that should be able to make the right moves to keep competing successfully in a changing marketplace.

Investing in blue chip stocks can give you an additional measure of safety in turbulent markets.

Rules for investing in the best blue chip stocks

We feel most investors should hold a substantial portion of their investment portfolios in securities from blue chip companies. These stocks should offer good “value”—that is, they should trade at reasonable multiples of earnings, cash flow, book value and so on. Ideally, they should also have above-average growth prospects, compared to alternative investments.

Here are three suggestions for investing in blue chip stocks:

1. Spread your stocks over most if not all of the five main sectors.
2. Invest mainly in high quality stocks.
3. Avoid or downplay stocks in the broker/media limelight.

It is possible for high-risk investments to work out? Do you agree, or have you only been burned by high-risk investments that you’ve made?

High-risk investments can seem promising, but that’s often an illusion. Share an example of when you have fallen into the trap of an alluring investment only to find it’s a disappointment.