How can low risk lead to high returns?

I received an very interesting private message from a reader yesterday which asked a rather good question, so I'd like to share my reply with everyone here.

The question goes like this:

{Quote)

Your posts are mainly really on penny stocks. Sapphire. yongnam.. (besides osim which u are not recommending a buy)
But you said "High returns Low risk" ?

I just find it a little contradictory. Maybe you can enlighten me a little.

(Unquote)

One of the most common things we first learn about investing is this phrase: Low risk leads to low returns, and high risk leads to high returns. I want to say that the statement is absolutely true, but we must view it in the correct context. The statement does not refer to stocks alone, but the entire investing universe of investment assets.

What it means is that investing in higher risk assets like stocks, derivatives, commodities, etc will give you higher returns, whereas investing in lower risk assets like bonds, fixed income instruments, etc will give you lower returns. Based on the statement, all stocks are considered as high risk assets, and it does not matter whether they are blue chips, penny stocks, index stocks, SESDAQ stocks, and yes, even REITs are included.

Let me address the second part of the question now. There is another common perception that blue chip stocks and/or high dividend yield stocks are less risky compared to penny stocks. In my opinion, this perception is completely untrue. Why do I say so?

Firstly, we must understand that as long as we invest in stocks, we are taking on a significant amount of risk already in factors like poor management, industry slowdown, natural disasters, etc. These risks are beyond our control, so excluding those, the biggest risk involved with stock investing to me is lack of knowledge. I touched on it in another post here, but the basic idea is that if you don't know what you're doing, you wouldn't know what to buy, when to buy, when to sell, and if you make any profit is is only down to luck, and we all know that luck will run out sooner or later.

Secondly, making money from stocks is based on this very simple concept: you make money when the price goes up, and you lose money when the price goes down. Based on that, a low risk stock would be a stock whereby the possibility of the price going down is very limited, right? But in a market correction, we all know that even solid blue chip stocks like DBS can fall as much as Yongnam or any other small cap or penny stock. Simply put, all stocks will suffer, regardless of whether they are blue chip or penny. Anyone who wants to invest in stocks must understand this concept: As long as a stock is expensive, the risk of the price going down is very high.


Thankfully, there is a solution to that, and that is to buy undervalued stocks. This simply means that if you buy a stock cheaply enough, it is less likely that it will go down in price. Take DBS as an example again. Because DBS is a stock, investing in it will carry all the risks normally associated with stocks. And if you buy it at $25, don't you agree that you are taking quite a risk because the possibility of its price going down is quite high? However, the risk is almost minimal if you can buy it at $5 because it is highly unlikely that the price would go much lower than that.

With regards to my strategy, I believed then that buying Yongnam at 3cts was a very low risk investment because after considerable analysis, I concluded that the price would not go down much further. On the other hand, I considered DBS at $20 a riskier investment because it could very well go down to $16.

Adding on, that also does not mean that a stock is more undervalued simply because it is cheaper. How much a stock is valued depends on factors like its owned assets, it cash holdings, and its profits generated. Based on those factors, if a stock was valued at $10 , it would be undervalued at $5. But if a stock was valued at 1 cent, then even 20 cents would be overvalued for it.

I hope that helps to explain how I determine whether any stock, blue chip or penny, large or small cap, is risky or not. I know the explanation is a little lengthy, but if you don't understand it at first, try reading it over a few times. The best way to understand it is to actually own stocks are to experience the fluctuations yourself. The concept will be easily understood then.