Are you missing out on this investment secret?

The market pays you a bonus for taking on risk. You make way more money by investing in risky things like stocks than safe things like cash or bonds. What’s meant by risk exactly?

I got a bit of a grilling the other day.

It was a wet afternoon and I was in a private room above a restaurant in Southwark, near the Agora Financial UK offices. A couple of colleagues and I were meeting for a few hours to talk penny shares.

I have an idea for a new report on the penny share market, you see. And the way things work around here is that I pitch the idea to my colleagues over the course of a few hours. If they like it, we’re in business. My colleagues, Ben Traynor (of The Daily Reckoning fame) and Glenn Fisher (our Publisher) critique the report, make suggestions, and generally help me make it great.

If they don’t like the idea… I hear all about it! The purpose of the long meeting I had on Tuesday is to poke and prod at the idea, test it from every angle, and generally make sure it “stands up”.

On Tuesday Glenn was playing the sceptic. He was forcing me to justify every point I made, in detail.

I’d said that you’d be an idiot not to invest some money in penny shares, because their performance trounces the performance of every other major asset class, including the shares of big companies.

Glenn: “Prove it.”

Risk pays

Yesterday, I wrote about the relationship between risk and rewards. I even called it the most important idea in investing.

The basic idea is that the market pays you a premium – a bonus – for taking on risk. So you make way more money by investing in risky things like stocks than safe things like cash or bonds.

What’s meant by risk exactly? Well, in the financial world “risk” has a specific meaning. It means volatility, or the tendency of an asset’s value to fluctuate one way and then the other.

Nobody likes the idea that their portfolio could suddenly drop in value tomorrow morning. It’s stressful! And what about if you need to sell tomorrow? What if you have to pay for retirement? Risky assets aren’t right for everyone.

To illustrate this point yesterday, I showed this graph. It shows how the returns from stocks have hammered the returns from bonds over the years.

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This is all good stuff. But did doesn’t answer Glenn’s question! Why do small company shares trounce the performance of big company shares?

They call it “the small company effect”

When computers came on the scene, academics started to put them to work analysing returns from the stock market. One of the first things they spotted was a weird pattern in the returns from small company shares.

By the early 1980s, all the researchers and academics were in agreement. Decades of data showed that small companies performed better than big companies… and the smallest companies performed better than merely small companies.

The academics called it “the small company effect”.

For those investors lucky enough to know about it, and take advantage of it, the results have been astonishing.  $1 invested in big companies in 1955 would make an investor $3919 by now. If he invested in small caps, he’d have made $29,400. And if he invested in the smallest small caps (AKA penny shares), he’d have made $48,090.

For the record – small companies performed more than 12 times better than big companies. That’s an indication of how powerful the small company effect can be – though of course, I can’t say with certainty the effect will be exactly as powerful in the future.

So what’s behind the small company effect? It’s all to do with risk and reward. Just like the way that stocks trounce the returns on stocks because they’re more risky, small companies trounce the returns on normal stocks because… they’re more risky.

Penny shares are riskier than the shares of bigger companies. And that’s why, according to the Credit Suisse Investment Yearbook for 2015, penny shares have been the best investment class of them all the last few decades. They beat the returns on big stocks, hedge funds, gold, bonds, and alternative assets like art.

Penny shares allow canny punters to take on greater risk… and reap the extra return that goes with it.

So there you have it. The market loves a risk taker. Don’t miss this trick!

Tomorrow, I’m going to give you a few practical tips on how to take advantage.

The Penny Share Letter is a regulated product issued by Fleet Street Publications Ltd. Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Seek independent financial advice if necessary. Fleet Street Publications Ltd is authorised and regulated by the Financial Conduct Authority. FCA No 115234 www.fsa.gov.uk/register/home.do.

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