Risk… It’s a word that makes most investors think twice. But should it be?

Bill Miller knows a thing or two about risk. As one of Legg Mason’s portfolio managers, he was responsible for managing a sizable chunk of the firm’s $923 billion in assets under management and did it well — he beat the market for 15 consecutive years before 2008 pushed his fund’s value down 31%.

His funds took a risky position in Fannie Mae — becoming its largest shareholder months before its government takeover in September and 98.8% decline in share price.

Risk probably isn’t something you want to expose yourself to, especially when it comes to your portfolio. And it makes sense — when your money’s on the line, why take a chance?

However, it’s not necessarily a bad thing…

Risk can actually be something you want to expose your portfolio to, not avoid. The first step is understanding the risk-reward tradeoff. As a general rule, the more risk an investment has, the more profit potential you’ll see. This makes sense — you wouldn’t buy a risky stock that promised to return the same as a stable blue chip. There has to be some sort of risk premium in the picture to get investors interested.

Beating the Risk-Reward Tradeoff

To be a successful penny stock investor, it’s time to make friends with risk. Don’t think of the risk-reward tradeoff as a restriction on your ability to make money…it’s not, as long as you know how to beat it.

How do you do that? Remember this rule — Know what you own. For some reason, scores of investors think that bonds are safer than stocks, blue chips are safer than penny stocks period. And while that’s not far from the truth, it’s not exactly the whole truth either.

Our economy has done a pretty good job of proving this lately. While “rock-solid” companies like Bear Stearns, Lehman Brothers, and Wachovia have been under the gun, the small-caps and penny stocks found in the Russell 2000 are up 14% this summer. Generally speaking, blue chips are safer investments than penny stocks…but that doesn’t mean that each blue chip out there will hold up to the market better than each penny stock. There’s always a Lehman or Wachovia lurking somewhere.

Profiting from the Pennies

How can you capitalize on those high performing pennies that break the risk-return mold? For starters, be careful where you put your money. Avoid small-cap index funds — indexes are essentially averages, and you can’t beat the averages if you’re betting on them.

Make sure you buy individual stocks that you understand inside and out. When you know what’s going on with a company, you minimize the amount of risk you’re exposing yourself to.

You also have to have a way to measure whether a company is expensive or undervalued. You don’t want to buy a stock if it’s already been overbought.

Lastly, it’s important to be aware of the company’s industry. If you think there’s a good chance the industry will do well, it may be a signal to start looking for a small-cap in that market. We’ll be sure to tell you when something catches our eye…

Cheers,
Jonas Elmerraji
September 29, 2008

Jonas Elmerraji

A big-four public accounting alum, Jonas Elmerraji brings his readers extensive expertise in small-cap stocks and broad market moves. Elmerraji’s interest in the market started with an investing course in elementary school – today he holds a degree in financial economics from UMBC and specializes in blending fundamental and technical analysis. Elmerraji has contributed to Forbes, TheStreet.com, and Investors Business Daily among others. He is managing editor of the Penny Momentum Trader, and a co-editor of Penny Stock Fortunes.

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