(FORTUNE Magazine) – Despite all the trading they do, pension fund managers produce surprisingly disappointing results. Though the rate at which they turn over securities holdings has risen sharply over the past decade, the returns they achieve don't even match Standard & Poor's 500 for the past five years. One reason is that they fail to adhere to some basic principles in setting investment priorities. These tenets may appear to defy common sense, but that's the secret of their value.

-- Investments must have potential for embarrassment. Institutional investors don't like risk, because it exposes them to the loss of their jobs. Like most agents acting for others, they respond to an asymmetrical payoff system in which failure is a direct penalty to the agent and success is usually a direct profit to the owner. So, overlooking the fact that high-risk investments may be priced to fully discount the risk, pension fund managers too often ignore this opportunity for hefty reward.

-- Illiquidity is an opportunity for greater return. Pension funds are attracted to highly liquid securities like government bonds and widely traded stocks. Yet the funds usually don't need much liquidity; their cash needs are often 20 years or more in the future. While liquidity may be prized as a means of reversing mistakes, the tangible benefits derived are often illusory in an age of instantaneous communications -- as became clear on October 19, 1987, the damage is done before the liquidity can be used. Liquidity may have value to the investment manager by giving him the opportunity to buy and sell often, helping to justify his fee. But it doesn't do much for long-term investment return for stockholders and beneficiaries. The move of companies from the public market to the private market to obtain capital suggests that private investors are willing to give up liquidity in order to receive higher returns. Pension funds have put some money into leveraged buyouts, but only a fraction of what they might. This is but one instance in which they have not fully recognized the opportunity inherent in trading unnecessary liquidity for higher return. And their concentration on increasingly short-term investments may actually be adding to stock market volatility and the very potential for embarrassment that they try to avoid.

-- Investment horizons shouldn't be the same as everybody else's. Institutional investors appear to favor three to five years as holding periods. Opportunities to do better than the average lie in being different. A ( strategy that goes to one extreme or the other, or to both, is preferable.

-- Dissent is good. Committee decisions, the rule in much of pension fund management, tend toward the bland, the already successful, the conventional. Committees rarely innovate, and find it hard to muster collective courage. The investment committee that recognizes the danger in this comfortable consensus will come to view dissent as essential to developing a strategy that achieves better than average results. Investing is not for the faint of heart. Once fund management meets the test of these principles, rewards can be large and risks manageable. While any individual investment may be risky, a diversified portfolio can produce a low-risk result. In 1830, Justice Samuel Putnam of Massachusetts ruled that trustees should manage funds as a well- informed businessman would run his personal portfolio. Do you know any well-informed businessman who runs his own money the way his company's pension fund is run? The purpose shouldn't be to control risk and only as an afterthought make a profit.