The Pros and Cons of High-Risk Investments
When it comes to investing, nothing comes without a price.
When it comes to investing, everyone has their own tolerance for risk. That tolerance can vary depending on your financial situation, your financial goals, your age, and many other factors.
Most people are comfortable investing in some stocks, understanding that the potential for positive returns is usually worth the risk over time. Others avoid the stock market altogether and are comfortable keeping their money in safe havens like bonds or basic savings accounts.
There are some investments that offer the potential for higher-than-average relative returns, but they also come with a heavy dose of risk. These high-risk investments aren’t for everyone, but they could help a person on the path the wealth if they have the stomach for it.
Let’s examine the potential benefits and drawbacks of some higher risk investments.
An investor who is looking to make more money can use borrowed funds to increase the potential return on any investment. It’s possible to see twice or even three times a typical return using leverage, but there’s an equal risk on the downside. Remember: leverage can magnify both your gains as well as your losses.
There are many leveraged products out there, including exchange-traded funds with double or even triple leverage. For example, you can invest in a triple leveraged S&P 500 ETF that will offer three times the return of the index. Of course, this means you lose three times the money if the market goes down. Moreover, the returns of these leveraged ETFs are based on the daily returns of the index, so you can lose quite a bit of money in a single day.
Leveraged investments may serve a purpose for some investors, but are rarely good products for those with a focus on the long term.
Trading in options is a potential way to make money off stock or other security even if the market isn’t going up.
When you buy an options contract, you are essentially buying the right to purchase or sell an asset at a set price before a certain date. For example, you may enter an agreement to sell 100 shares of Apple stock at $150 per share. If the stock is trading for much less at that point, you make money.
There are kinds of options that can result in large or even unlimited losses, especially for sellers. One example is a naked option, an investor can bet against a stock and lose a lot of money if the stock goes up. For example, let’s say that you believe Apple’s stock will not rise above $150 per share. You enter into a contract with a “strike price” of $150 set to expire in June of 2019. When June rolls around and Apple is trading at $210, the investor loses the difference or $60 per share. In theory, a loss is unlimited because there is no cap on how high a stock price can go.
It can take time to understand the ins and outs of options, so trading should be done by more experienced investors. Even those who claim to know what they’re doing can lose large sums of money.
It’s common for older investors and retirees to invest in the fixed income market through corporate and municipal bonds and U.S. Treasuries. These types of investments rarely default and offer a steady, predictable stream of income. But it’s possible to get higher returns from bonds if you are willing to purchase riskier debt. This is called the risk premium.
Most bonds come with ratings based on the credit-worthiness of the borrower, with AAA ratings for the most reliable bonds and ratings as low as CCC or even D for the weakest bonds. Bonds with low ratings are often called “non-investment grade,” “speculative” or “junk” bonds.
It’s possible to make good returns off low-rated bonds, as a low rating is not a guarantee that the borrower will default. But it’s rarely a good idea to put a large percentage of your money in these types of bonds.
The values of currencies can change quickly and dramatically. Your ability to predict and act on these movements will determine your success in making money on the foreign exchange market, or forex. The wild swings of currencies, especially outside the U.S., offers the potential for high returns if you forecast the changes correctly. But trading on the forex is not for the faint of heart, as a wrong bet on a currency can result in the loss of everything you have invested. To make matters riskier, currencies are often traded using leverage, so your losses can be multiplied.
When trading currencies, it’s best to avoid having too much money tied up in one trade, avoid using leverage, and to use stop-loss orders to prevent major losses.
Emerging and Frontier Markets
The U.S. stock market has reliably risen in value over time, so finding true bargains is not always easy. That’s why many investors look abroad to fledgling economies for growth opportunities.
It’s possible to invest in equities and debt from emerging economies such as China, India, and many countries in South America, Africa, and Eastern Europe. These countries are earlier in their growth cycles compared to the United States, so there's potential to see investments rise in value over time.
Frontier markets are usually smaller and even further behind emerging markets in terms of growth but still may offer opportunities for investors. Countries such as Estonia, Vietnam, and Kenya are often considered frontier markets.
Emerging and frontier markets offer opportunity but come with risk. These countries are often not as stable economically or politically. They have been known to default on debts. Their markets can be far more volatile and unpredictable than the U.S. It’s not a bad idea to mix emerging and frontier investments into your portfolio, but be sure to balance them out with safer and more reliable assets.
Most investors are accustomed to seeing publicly traded stocks on major exchanges like the New York Stock Exchange and NASDAQ. But many companies are too small to be listed on these exchanges, and therefore trade “over the counter” or on the so-called “pink sheets.” You can buy shares of these companies on the cheap, and if they ultimately explode in growth, you can make a lot of money.
Keep in mind, however, that these stocks are trading over the counter because they were de-listed from major exchanges or were never large enough to be listed in the first place. A large number of these penny stocks never rise in value. In fact, many of these tiny companies barely report any sales or income at all and exist only on paper. Moreover, penny stocks are often the subject of price manipulation, in which dishonest people promote a company's shares to pump up the stock price and then sell at a profit.
The number of exchange-traded funds has grown dramatically in recent years. There are now more than 2,900 ETFs available to investors, and many of them have very specific and unique investment goals. There are ETFs tied to just about any market and index imaginable, with many designed to offer potentially high rewards in exchange for high risk. There are several ETFs, for example, that attempt to mirror the VIX, or volatility index. There are also inverse ETFs designed to go up when the market goes down (but potentially vice versa.) These types of investment could offer the potential for higher returns that more mainstream investments, but also can expose an investor to potentially higher losses.
The general advice to average investors is to stay away from these types of niche products.