How’s this possible?
Small-cap stocks are safer than blue-chip stocks?
That’s what a report from Bloomberg says.
We knew it. We’ve said it all along.
But Bloomberg isn’t talking about any old small-cap. They’ve got a specific kind of small-cap in mind…
Free Reports:
According to the Bloomberg report:
‘China’s riskiest companies are proving the safest bets for stock investors.
‘The E Fund ChiNext Price Index exchange-traded fund, which tracks the benchmark gauge of the nation’s small-capitalization stocks, has delivered the highest risk-adjusted return among 23 Chinese ETFs during the past four years as a 67 percent gain compensated investors for bearing the highest volatility. The 50 smallest initial public offerings in that period have surged 151 percent on average, versus a loss of 22 percent for the largest deals…’
It’s counterintuitive, but there are times when it’s safer to own small-cap stocks than it is to own blue-chip stocks.
Clearly for investors in China’s market that has been true over the past four years. And it’s not just large-cap IPOs that have taken a pasting. As we’ve pointed out before, China’s benchmark CSI 300 index is still down more than 60% since the 2007 top.
It has been a terrible time for blue-chip investors in China. But is that about to change?
First off, how can a qualified financial adviser say that sometimes it’s ‘safer’ to own small-cap stocks than it is to own large-cap stocks?
We’ll bet that you couldn’t find another financial advisor, fund manager or stock broker in Australia who would agree with that view.
And yet it’s true.
How so?
Simple. It’s to do with an investor’s attitude to risk and their expectations for returns.
Let’s use a seemingly extreme but realistic example. Let’s say that during 2007 an investor put 90% of their money in ‘safe’ blue-chip stocks. They did that because they wanted ‘safe’ dividend returns.
They also didn’t want to speculate. They bought the banks, retailers and a few industrial stocks — Aussie icons. What could go wrong? Not much, they thought, because they’re a safe and conservative investor.
Now let’s take another investor, a speculator. This investor likes to punt on stocks. But they also know the risks of speculating. So this investor put 90% of their money in the bank to earn a steady interest income.
With the other 10% they bought a few high-risk stocks. This investor wanted to make 100%, 200% or even 1,000% on their money. They also knew that if things went bad they could lose all their money, which is why they only speculated with 10% of it.
What would have been the outcome for these two investors in 2008 and 2009 when markets crashed?
Well, the Aussie market halved in value. The investor who put 90% of their money into so-called blue-chip stocks saw the value of their shares fall by half.
If they had invested $90,000 in stocks, by March 2009 that would only be worth $45,000. Add that to the $10,000 they kept in cash and they’ve got $55,000.
On the other hand the ‘speculator’ still has $90,000 in the bank. That investor is already ahead of the ‘conservative’ blue-chip investor. Even if the value of all of this investor’s small-cap stocks went to zero, they’re still ahead of the game.
While 2008 was bad for investors, not many Aussie small-cap stocks went to zero. In fact, the S&P/ASX Small Ordinaries index fell 62% from the peak in 2007 to the bottom in 2009. So the speculator would have a paper loss of $6,200. In other words, this investor would still have a total portfolio value of $93,800.
The point here isn’t to say that you can lose less with small-caps or even that you should sell all your blue-chip stocks and buy small-caps.
The point we’re making is that when you invest, you need to take into account the risks you’re taking in return for your expected reward. Far too many investors think they’re smart because they put all their money in blue-chip stocks without considering what could happen.
That brings us back to China and the entire idea of emerging markets investing.
For years investors have taken the same view on emerging markets investments as they have small-cap stocks.
They see them as too risky for the average investor…far riskier than safe old Australian stocks. Most financial advisors will tell you that you should leave emerging markets to the pros and just concentrate on buying Aussie stocks.
That way you’ll be fine.
That sounds good in theory. But in practice, maybe not so much. As the following chart shows, even if you consider yourself to be a buy-and-hold investor, over the last nine years you would have been better off being a buy-and-hold investor in ‘risky’ Chinese stocks rather than ‘safe’ Aussie blue-chip stocks:
The S&P/ASX 200 index is up 32.2% since 2005. Even after the big boom and bust in 2008, China’s CSI 300 index is still up 114.2%.
Again, we’re not saying sell everything Aussie and buy everything Chinese. What we are saying is that most investors have a poor understanding of investment risk and expectations.
This is something we’ll cover in more detail over the coming weeks. We’ll include specific details on ways to profit from key market trends.
Cheers,
Kris+