How You Can Earn High Returns with Low Risk

Is it possible to earn high returns while taking on lower risk? This might go against the general assumption that high returns has to be accompanied by high risks, but the act of being a business-focused investor can actually help us produce superior results without taking on too much risk. Here’s why.

Evaluating risk

Suppose you’re now back in August 2008 and you’re interested to invest in Singapore Telecommunications Limited (SGX: Z74). Back then, Singapore’s largest telco was trading at around S$3.50 a share.

You had spent some weeks performing research on the company’s financials, business prospects, and management team, and came up with an estimate of its intrinsic value using a discounted cash flow analysis. As it turns out, the intrinsic value of SingTel that you punched out from your calculator is higher than what it was trading at back then – that’s great! It means that SingTel looks undervalued to you.

However, before you had a chance to invest in the company, the Global Financial Crisis went into full swing, causing stock markets everywhere – including the shares of SingTel – to sink. Within weeks of August 2008, SingTel’s shares had fallen by more than 40% from S$3.50 a pop to a low just north of S$2.00.

Now, this is where it gets interesting.

If you had concluded that SingTel was a bargain at S$3.50 apiece, SingTel at S$2.00 would prove to be an even better bargain – the potential returns from buying at S$2.00 would be a lot higher than from buying at S$3.50.

In addition, SingTel being priced at S$2.00 would mean that the gap between its price and your estimate of its true business value is much larger as compared to when the share was priced at S$3.50. That larger gap between what SingTel is really worth, and what it’s selling for, thus makes the investment less risky.

Foolish Summary

So as you can see, when you’re a business-focused investor, you’re always comparing the difference between a share’s price and its real intrinsic value. And by doing so, you’d be able to achieve higher returns with lesser risk.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim does not own any companies mentioned.