How to Profit From Risky Stocks

Many people avoid stocks because they're too risky. But just like a high roller can get rich with a single run of good luck, the riskiest stocks often turn out to be the most lucrative for those who are willing to roll the dice.

The question, though, is whether that makes them good investments. The simple answer is that if you focus too much on results, you'll draw the wrong conclusions about where you should invest your money -- and eventually, risks will finally catch up with you.

Crying wolf
About a year ago, Forbes ran an article talking about some high-risk stocks that had seen big run-ups since the market meltdown the year before. Dubbing the group of 10 stocks "The Risk List," the article explained how it had gone to research firm Audit Integrity to analyze 2,700 stocks and come up with the ones with the highest amount of financial risk.

In particular, Audit Integrity looked beyond obvious financial metrics like net income and outstanding debt. It also used its proprietary Accounting and Governance Rankings (AGRs), which Audit Integrity's founder created in order to give investors a measure of how likely it is that a company will have to make restatements to its financials or have to deal with SEC inquiries or shareholder lawsuits.

After seeing the candidates, I was curious what happened to these 10 stocks over the past year. I found the results a bit surprising:

Source: Forbes, Yahoo! Finance.

Trusting Audit Integrity's numbers to translate to immediate results, I fully expected to see at least a few blowups among its top 10 picks. But as it happened, none of those major risks led to anything during 2010. From higher load factors for air travel to Kodak's reinventing itself in the postfilm era; from a rebound in senior assisted living to a renewed love for Rooty-Tooty Fresh 'n' Fruity breakfast specials; these stocks all avoided the great beyond for another year. As a result, those who had feared such an occurrence ended up with a better 2010 than they had expected, leading to some really huge stock jumps as investors regained confidence.

What risk means
Those results may not sound right to you. But when you look more closely at the analysis, you'll realize that these numbers don't mean what you might initially think. Audit Integrity said that the top 100 riskiest companies had an average chance of around 8% of going bankrupt during 2010. Certainly, an 8% chance of losing everything would be scary to a shareholder. But if you knew that you could double your money if that 92% probability that the company wouldn't go bankrupt occurred, then it would make taking the risk a lot more attractive.

It's easy to take that thinking too far, though. Just as you shouldn't avoid minuscule chances of losing your shirt if the potential rewards are great enough, you also shouldn't ignore those default risks if you're not getting adequately compensated for them. That's the problem that investors in subprime mortgage-backed securities learned the hard way after the housing bubble burst. When times were good, getting some extra yield seemed like free money. But when the bottom fell out of the mortgage market, that bump in yields paled in comparison to the complete losses of capital these investors faced.

Manage your risk
As an investor, you're never going to eliminate risk. The key to investing well is to understand and manage the risks involved by estimating how a stock will respond to various scenarios. Even though some investments won't work out the way you expect, if you balance risk and return correctly, then you'll make money over the long haul.

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