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This column originally appeared in Forbes.

On my latest appearance on CNBC's "Capital Connection," with Chloe Cho, one of the hosts asked me if Western investors should invest in China right now. I may have surprised many who know I think China is the growth story of the 21st century. I said retail investors should think twice about investing directly in Chinese companies listed in the U.S. and might be better off not investing unless they can stomach real risk.

Why? First, Chinese company stock prices remain very volatile, because of hedge funds. There are only several dozen good Chinese companies traded on the New York Stock Exchange and NASDAQ, so hedge funds control an inordinate amount of Chinese equity. If they grow bearish or need liquidity, they might sell stakes quickly. Second, despite some improvement, the transparency of Chinese firms remains questionable. My firm, the China Market Research Group, once conducted due diligence on a publicly traded firm for a client who wanted to invest $50 million. We found that the company was booking as revenue deals that had not been signed but that potential clients had orally promised years before. Many Chinese companies keep three sets of books, one for the tax bureau, one for investors and one for senior executives.

Aside from business risk, never underestimate the political risk inherent in much business in China. For instance, I told the anchor I was not overly optimistic about Agricultural Bank of China's initial public offering or about investing in other state-owned enterprises, because they are more political tools than true profit-seeking ventures.

What is good for the economy is not necessarily good for investors. One reason China's economy remained robust during the Great Recession is because Bank of China and ICBC loaned money under central government direction to get liquidity into the system. That was undoubtedly good for the economy, but it wasn't great for investors who will have to deal with years of rising non-performing loans. Also, senior executives at large state-owned banks care more about jockeying for political power than making money. Most of China's senior central bankers previously worked in the big state-owned banks, and many have even been rotated between banks by government appointment. Imagine if President Obama directed Lloyd Blankfein to leave Goldman Sachs (GS) to work for Morgan Stanley (MS) for a few years before moving to Bank of America (BAC) and then replacing Ben Bernanke at the Fed.

In order to stave off high gasoline prices, the government could force the oil giants Petrochina and Sinopec to freeze prices at the pump, even if it killed their margins. It is true that sometimes the government will want state-owned enterprises to make money, but if you invest in them you need to be a political expert more than a business analyst.

Even when investing in private Chinese companies you need to take politics into account. A sudden morality campaign by the government might mean shutting down things like micro-blogging sites without warning, or imposing limits on online gaming (gaming addiction among youngsters is increasingly being viewed as a serious social problem). That would hurt the stock prices of online game companies like Netease (NTES), Shanda (SNDA) and Sohu (SOHU).

With so much risk, how should retail investors get exposure to China? One way is to buy the stocks of Western companies that generate significant revenue there, like Yum Brands (YUM), or in assets like Rio Tinto (RTP) that help satiate China's huge demand for commodities. Yum generates 40% of its global revenue in China and is well-positioned for continued growth despite rising labor costs, because the yuan will continue to appreciate.

If you are a bit more adventurous, invest directly in Chinese stocks that are traded in the U.S. or Hong Kong. You can now buy Hong Kong-listed stocks via E*Trade. Make sure you do your own homework and analysis and ignore the recommendations of so-called China watchers who don't actually live on the mainland. I am constantly surprised at how many people become China experts despite having never lived there, not speaking Mandarin and only traveling there once or twice a year at most. Trust them at your peril.

If you do invest directly in Chinese companies, look for companies that are riding the wave of these three growth megatrends there:

First, the Chinese are increasingly looking to travel. More than 50 million of them traveled abroad last year, and Chinese tourists have become the single largest per capita spenders among tourists to France. Chinese consumers are the new Japanese consumers of the 1980s. They are buying $9 billion a year worth of luxury goods, 60% of that abroad while traveling. Look at investing in companies that cater to the growing travel and leisure sector and to Chinese travelers' demand for premium products.

The second trend is the increasing purchasing power of women. Women now account for 50% of China's household income, up from 20% in the 1950s. There are now more women than men studying at universities. Invest in better-branded companies that emphasize safety and health and have built trust with Chinese women.

Finally, the biggest growth for most companies will come not from first-tier cities like Shanghai and Beijing but from second- and third-tier ones like Dalian, Chengdu and Hefei. Invest in companies that have not only strong distribution and sales channels in those places but also strong branding.

China's economy remains strong. The government has engineered a soft landing in the real estate sector, and the excessive lending to local governments that occurred in 2009 has eased. Nonetheless, investing in Chinese companies can be rewarding but is full of volatility and risks for Western investors.

Disclosure: No positions

Source: How to Invest in China