This Stock Has Tremendous Upside

There is no such thing as a low-risk stock.

That's the enduring conclusion of 2008, a year in which ostensibly government-backed companies Fannie Mae and Freddie Mac imploded and former "dividend achievers" AT&T (NYSE:T), Medtronic (NYSE:MDT), and Citigroup each dropped by 25% to 75%.

Without low-risk stocks, it might seem that retail investors like us are left in the lurch. After all, conventional wisdom -- printed and distributed by just about any mutual fund salesperson or financial advisor -- posits that large-cap stocks carry lower risks than small-cap stocks and that U.S. stocks are "safer" than foreign stocks.

What happens in a world where there are no "low-risk" stocks?

This isn't bad news at all, actually
Let's say that you called yourself "conservative" a few years back when developing an asset-allocation game plan. You would've loaded up on large-cap U.S. stocks such as AIG (NYSE:AIG) or United Technologies (NYSE:UTX).

Conversely, if you labeled yourself "aggressive," you might have been told about an up-and-coming small cap such as Boston Beer (NYSE:SAM) or an emerging-markets play such as ICICI Bank (NYSE:IBN). Even a self-identified aggressive investor, however, would probably not have been introduced to a small and foreign company such as Cogo Group (NASDAQ:COGO). Too risky, right?!

Not really. Those designations are arbitrary, and though I've constructed the following table by cherry-picking specific stocks, the sector-specific indexes aren't far off:

Data from Morningstar.

Point being: Those arbitrary designations of risk haven't been predictive this year. Yes, United Technologies held up better than its peers in this small sampling, but AIG, the other "safe" stock, fared worst of all.

What safe stocks will get you
Yet you pay a cost when you invest in the stocks the establishment considers safe. Namely, lower returns:

Data from Morningstar.

It's true that Cogo Group has been wildly volatile since 2003, while United Technologies has had only one down year (this one) over the same time frame, but Cogo’s five-year annualized return is superior.

While it's no hard-and-fast rule, this example illustrates that with "safe" stocks, you get limited upside, and in periods of stress, you risk the same unpredictable downside you'd find in small, foreign, or even small and foreign stocks.

You may be thinking there's no chance that a conglomerate like United Technologies will ever drop 97% in a year. I wouldn't bet on seeing that happen, either. But the fact remains, a few years ago, that scenario didn't seem at all possible with global banking and insurance behemoth AIG, either.

How to proceed
I got to thinking about all of this recently while rereading The Black Swan, in which Nassim Taleb sets out to show that the bell curve is bunk and that the future is shaped not so much by a succession of high-probability events, but rather by a small number of high-impact, seemingly improbable or impossible phenomena. On a sociopolitical scale, this includes events such as the terrorist attacks of Sept. 11, 2001. On a financial scale, it includes 40% market drops that cause you to realize that there are no low-risk stocks.

Yet just as there are negative black swans in the world, such as wars and market drops, there are positive black swans, such as the discovery of penicillin or the invention of the computer. When you invest in the stock market, Taleb asserts, it's these positive black swans (and their tremendous upside) that you want exposure to.

So where can you find them?

Here's where you won't find them
You won't find tremendous upside potential amid the same tired U.S. large caps that financial analysts have been writing about and recommending for decades. Rather, you need to look at small stocks (Taleb points to biotech as a promising sector for positive black swans), at foreign stocks, or at small foreign stocks such as American Oriental Bioengineering.

It's these types of companies that have the opportunity to surprise the world and the market, and given the resources waiting to be harnessed in emerging economies such as China and Brazil, their multiyear growth potential is enormous. And because investors are fleeing to "safe" U.S. large caps in these times of turmoil (using those faulty risk assumptions), right now you can gain exposure to the tremendous upside potential of emerging markets -- for cheap.

Take risks on your own terms
Taleb's theories and their implications for portfolio construction are a hot topic for debate, and he makes an important point when it comes to ensuring that you're aware of -- and being properly compensated for -- any risks you take.

If there's anything you can learn from 2008, it's that there are no more "low-risk" stocks. All stocks carry risks -- don't let artificial designations of "aggressive" or "conservative" make you think otherwise.

That's not to say you should get out of stocks. Assuming you've put away any money you need to protect in Treasuries or insured interest-bearing accounts, at Motley Fool Global Gains, we think that today's valuations offer a great opportunity to invest in the world's emerging economies.

The risks there are real, but tremendous upside opportunities abound. What's more, our travels to China, Indonesia, and Brazil have brought us in contact with a few companies (including Cogo Group if it were a bit cheaper) that we believe have the opportunity to grow and reward investors significantly for the next decade or more.

You can see our entire list of recommendations, and read all of our emerging-markets research, by joining Global Gains free for 30 days. Click here for more information.

This article was first published on Nov. 20, 2008. It has been updated.

Tim Hanson owns none of the securities mentioned in this article. The Fool's disclosure policy recommends you read The Black Swan in its entirety.