Why Risky Stocks are Best in Risky Markets

If you’re like most investors you probably think it has been a terrible period for Chinese stocks.

That’s a fair assumption.

You’ve seen news about commodity prices crashing. And everyone knows that’s because Chinese economic growth is slowing.

But what if we told you a certain type of Chinese stock is killing another type of Chinese stock by more than 20 percentage points?

And what if we told you a similar story is playing out in the Australian market? Well here’s the good news: it is…

But first, back to China and the Chinese markets.

Yesterday the Financial Times reported:

Following the recent rout in global emerging markets, the Shenzen composite – home to China’s small-caps index – is up 13.8 per cent this year, outpacing gains in the next best Asian market, the Philippines.

The move is not a reflection of new-found confidence in China. The Shanghai Composite remains Asia’s most unloved index, having fallen 8.6 per cent this year, partly due to the perception that it is a proxy for China’s old economy.

That’s not what most people would expect. Think about it. Name a high risk and volatile market – China.

Now name one of the most high risk and volatile stock sectors – small-caps.

Put them together in a market that’s taking a beating, and what do you get? A 13.8% capital gain apparently.

That’s the beauty of small-cap stocks, and it’s why so many speculators view them as the punting stock of choice…

Small-Cap Stocks Beat Blue-Chips More than 2-to-1

To novice investors it seems counter-intuitive to punt on the riskiest stocks when the market is so volatile.

But when you stop and think about it, it’s completely logical.

When they’re certain about the market and things look great, investors tend to take their money out of the bank to invest it in safe and reliable blue-chip income and growth stocks.

But when they’re not certain about the market and things don’t look great, investors tend to keep their money in the bank. But they still want some exposure to stocks just in case the market takes off.

That’s why small-cap stocks are so popular. You can keep most of your money ‘under the mattress’ and just invest a small stake in small-cap stocks.

And because small-caps can move so quickly in either direction, investors can make big gains without having a lot of cash on the line.

But it’s not just in China that this happens. A similar game has played out on the Australian market. You can see that in the chart below. We’ve compared the S&P/ASX 200 index (blue line) to the S&P/ASX Emerging Companies index (red line) over the past two months:

Source: Google Finance

Over the past two months Aussie small-caps have gained 25.2% compared to just 9.1% for Aussie blue-chips. This confirms our call two months ago to recommend you buy the market (especially small-caps) when most other folks were running scared.

Use Your Big Picture Knowledge to Your Advantage

This is why we tell you to keep things in perspective when you look at big picture events.

It’s OK to read about an impending Chinese economic crash. It’s fine to understand what the markets think about the latest US Federal Reserve meeting and whether the Fed will stop or continue printing money.

In fact, it’s better than ‘OK’ and ‘fine’. You should know what’s happening to the broader economy. That way you can plan for the worst before it happens.

That said, you’ve got to make sure you don’t suffer investment paralysis by becoming so worried about things that you do nothing.

Understanding the big picture point of view should be an advantage. Knowing that the world economy could go pear-shaped any day puts you in better standing than the mainstream investors who just won’t see it coming.

So, now you’ve got that advantage, it’s up to you to do something about it. Our fear is that over the past month you probably missed out on the small-cap gains. And worse, that you probably missed out on the smaller blue-chip gains too.

As we’ve said for some time, the market is as risky as heck. Don’t fool yourself into thinking it’s anything but that. But if you take the time and the effort to look, you’ll soon see there is still a lot of good value in Australian stocks today.

Just don’t let investment paralysis get the better of you.


From the Port Phillip Publishing Library

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Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read. Money Morning Australia is published by Port Phillip Publishing, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.

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