When Rewards Outweigh Risks

Risk has quickly regained its status as a four-letter word.

No one wants to hear about it and no one wants to think about it. But those willing to take it on (pragmatically, mind you) will likely earn greater rewards than they would have at any other point in the past twenty years.

Right now, the herd is absolutely afraid of any risk at all…even good risks. My case in point is when the bond market went upside-down again yesterday. Investors were buying up the “safest” assets in the world as fast as they could.

At one point in the day, T-bills were yielding less than zero. Essentially, someone was willing to lend the government money for nothing, absolutely zero, in return.

It’s like selling dollar bills for 99 cents. It just doesn’t make any sense, but it does prove one thing; practically no one is willing to take on any risk right now. No one knows what’s going to happen next and the sidelines are a cozy, warm, and safe place to be. I can hear the beaten down hedge fund managers (that still has a job) now, “I may not get ahead, but I’m not going to fall behind either.”

You can certainly make a case for another drop in the markets and I still don’t think we’re completely out of the woods yet. Regardless, I still believe now is the time when the foundations of great fortunes are lain. And if you can make the right moves over the next year or so a great fortune awaits on the other side.

I’m not alone here either. Over the past few months we’ve all been inundated with quotes like Rothschild’s, “Buy when there is blood in the streets,” and Buffett’s, “Be fearful when others are greedy and be greedy when others are fearful” (granted, your editor has been generous with those quotes lately).

Despite how many times you hear it, it’s still the toughest thing to do with hard-earned money. I understand completely (truly, I’m about to have less cash in my portfolio than any point in the past years). Rest assured, by taking the right risks now, however, the rewards can be truly fantastic. Let me explain.

The Risk/Reward Ratio is in Our Favor

Why take risks now when no one else is willing to?

The simple answer is because the potential rewards are much, much bigger. And the downside is much, much lower.

Penny mining stocks provide the perfect example. They are by far the riskiest investment you can make…ever. The odds are almost always against you (except during extreme downturns like right now) and the rewards, although great, only occasionally offset the risk.

Despite most of the cards stacked against them, there’s usually a good bit of attention steered towards these uber-speculative investments. But here’s the thing, most of the attention comes at the worst possible times.

You see, after a multi-year bull market for commodities, a few dozen of these companies rewarded investors with quadruple-digit returns. A few of them even handed early investors gains of 2,000% and more. Naturally, after a few years and dozen big winners, greed set in and the herd was chasing the next one.

Here’s the thing though, quadruple-digit returns don’t normally happen in the middle or the end of the bull markets, they happen over the course of a bull market.

It’s not just the wild moves of penny stocks though. The same thing happened in fertilizer stocks, emerging markets, and dot-com highflyers like Yahoo and AOL. All of these delivered plenty of doubles and triples, but to those in early enough, the rewards were truly great.

By being early to these tidal waves of growth, investors could have reaped huge returns. A good return can be made by jumping on a wave when it’s going up, but truly great returns are made by riding a wave from the start.

Here’s the best part. At the start of the wave, the risks are lowest and rewards are greatest. And right now, it looks like the tide could finally be turning on emerging markets. We’re closing in on the point of maximum pessimism – when investors really can’t get any more risk averse.

From Doom to Boom

Over the past year, risk-aversion has been the name of the game. The big money, which flooded riskier emerging markets for the past few years, ran to the safety of home. The U.S. caught a cold and the big money wasn’t about to hang around to see how the rest of the world will deal with a bout of the flu.

As a result, emerging market shares have gotten absolutely pounded over the past year or so. The MSCI Emerging Markets Index has fallen 60%. Most investors can’t stand it and, as usual, want out at the worst possible time.

Redemptions in emerging market equity mutual funds continued. Research firm, EPFR Global, says $553 million was pulled out of emerging market equity funds at the beginning of December. The total outflows for the year is now $41.7 billion – the highest since EPFR began tracking it in 1995. In all, that’s almost half of what went into the funds over the past five years. Clearly, we’re reaching an extreme.

Despite it all investors are still fearful of further falls to come in emerging markets. At these prices though, emerging markets are actually a much safer bet.

As we’ve seen many times before, when everyone else is throwing in the towel, it’s the best time to get in the ring.

Finding Certainty in Uncertain Times

For a while now, I’ve been one of the biggest detractors of emerging markets stocks. From “Hong Kong is a disaster waiting to happen,” in late 2006 to “China is built for booms,” just a few weeks ago, I’ve been overall bearish on emerging markets stocks for a while (I understood the growth and opportunity, but not the valuations).

Now, that’s starting to change. There are much greater factors about to start impacting emerging markets far greater than redemptions of mutual funds and P/E ratios. The largest factor to consider, and the biggest catalyst for emerging markets over the long-term, is demographics.

Think about it for a second. The U.S. was an emerging market 100 years ago. The country was filled with young, able-bodied workers who could (and were willing to) run the steel mills, operate shipping ports, etc. Then in the 60’s the Baby Boomers took over and provided the big workforce necessary to extend five more decades of prosperity in the United States.

Demographics play a critical role in the future growth of all countries and regions. The ones with a young workforce of people willing to work and seeking out opportunity will have a significant advantage. Countries made up of older people are actually at a disadvantage.

Take a look at the chart below. You’ll see why emerging markets have a distinct advantage. (Please note these are just a few examples to help illustrate the point.)

Age of Nations

Demographics are just another reason to start delving back into emerging markets. On top of all that, most aren’t burdened with debt or face the legacy costs of an aging population. Even if they were, chances are they’d have a long enough time to work through it.

I’m not the first one to say it, but the world is changing. The difference this time (as opposed to a year ago) is the valuations on most of the stocks in the new world are reasonably attractive.

Buy Low/Sell High

At the end of the day, trying to time the market is eventually a losing game. With the markets moving up and down by 2%, 3%, 4% or more every day, you can make some wins for a while (heck, a very few will be able to do it successfully for years), but the odds are against you.

Investing and trading is a game of odds, risk, and reward. Right now, the risk/reward ratios in emerging markets and a few other sectors have turned in our favor. And it’s time to start delving in and finding out which companies are generating cash, taking the opportunity to expand market share, and are doing all the right things to come out of this recession much stronger.

Although it certainly doesn’t seem like it every day, it’s a great time to be an investor. At the Prosperity Dispatch, we still recommend buying conservatively with the consideration in mind that in order to sell high, we’ve got to buy low.

By Andrew Mickey

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