What if Blue-Chips Were Riskier Than Small-Caps?

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…

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?

Two investors, two portfolios

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?

Conservative investors underestimate risk

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.

Read the rest of this article at Money Morning